On December 11, 2014 call for biddings CNH-R01-C01/2014 was published in the Federal Official Gazette (“DOF”), whereby the National Hydrocarbons Commission (the Comisión Nacional de Hidrocarburos or “CNH”) of Mexico called national or foreign legal entities and the State's productive enterprises to participate in the first stage of Round One for the awarding of Hydrocarbon Exploration and Extraction Contracts (Contratos de Exploración y Extracción de Hidrocarburos, or “CEE”). During that Round One stage, the CNH will hold biddings for 14 contractual areas of exploration and extraction of hydrocarbons in shallow waters of the coasts of the states of Veracruz, Tabasco, and Campeche. As part of the bidding rules published with respect to that call for bids, the model contract for the first phase of Round One was issued (“MC1”), in two versions: one for consortium contractors and another for contractors.
Thereafter, on February 27, 2015, the second stage of Round One was issued in call for biddings CNH-R01-C02/2015, tendering nine fields for the exploitation of shallow waters in five CEEs in the Gulf of Mexico. Similarly, as part of the bidding rules for this stage, the model contract (“MC2”) was published in the aforesaid versions. This model contract contains significant differences with respect to MC1, in aspects such as the recording of costs, expenses and investments, procurement procedures, and intercompany transactions, among others.
In this regard, on March 6, 2015, the “Guidelines for the preparation and presentation of costs, expenses and investments; the procurement of goods and services in contracts and assignments; the accounting and tax review of contracts; and the updating of royalties in contracts and the hydrocarbon extraction fee” (the “Guidelines”) were published in the DOF by the Ministry of Finance and Public Credit (the “SHCP” for its Spanish acronym), among other things to avoid abuse in the acquisition of goods and the contracting of services at costs above market benchmarks, so as to ensure the maximization of the nation’s revenues. In this sense, it should be noted that, unlike MC1, MC2 is consistent with the Guidelines in the recording of costs, expenses and investments, procurement procedures, and intercompany transaction issues mentioned above.
This alert provides an analysis of the aforesaid issues in both MC2 and the Guidelines, emphasizing the differences vis-à-vis the provisions of MC1.
MC2 contains significant differences with respect to MC1, with regard to the procedure to determine the consideration of the State and the contractor, specifically with respect to the mechanics for calculating the Contractual Price of Hydrocarbons. The most important change lies in the fact that, unlike MC1, MC2 does not consider the possibility that the Contractual Prices may correspond to arm’s length prices in related-party transactions.
This is due to the MC2 definition of Market Rules, referring to the mechanism to determine the contractual price of hydrocarbons. In particular, MC2 defines Market Rules as the “competitive principle whereby the parties involved in a transaction are unrelated and participate in like conditions according to their own interest”. Under this definition, a related-party transaction is not carried out under the Market Rules principle, even if undertaken under the arm’s length principle.
MC2 Exhibit 3 provides a mechanism to determine the Contractual Price per type of hydrocarbon different from the mechanisms in MC1. The prices reported by the Contractor or Marketer in sales transactions under Market Rules are taken into account in the first instance, and solely when no such transactions have been recorded during the month in question, the formulas provided for this purpose are to be used. In particular, under MC2, the Contractual Price of Hydrocarbons shall be determined as follows:
Click here to view table.
Note that the Guidelines do not include specific regulations for determining the Contractual Price of Hydrocarbons and/or clear specifications on the interpretation and implementation of the definition of the Market Rules to which MC2 refers.
However, while MC2 provides that intercompany transactions for the sale of hydrocarbons cannot be used in the determination of the Contractual Price, this does not relieve the Contractor of the obligation to determine that the prices in such transactions are at arm’s length for purposes of complying with the Guidelines with respect to transactions with the related parties described in the following section.
Definition of Related Parties
While the definition of Related Parties under MC1 is linked to Article 179 of the Mexican Income Tax Law (“MITL”), such definition under MC2 corresponds to the definition included in the Guidelines. Both definitions are consistent with one another. In this sense, although each model contract provides a different reference, there are no relevant changes within such definition.
It should be noted that, given the above definition of related parties, once Pemex migrates its incentivized contracts and assignments to the new contractual models set out in the Hydrocarbon Revenues Law, the enterprises with which it forms consortiums or joint ventures will be regard as related parties thereof, with the associated tax and contractual obligations arising thereunder.
Furthermore, MC1, MC2 and the Guidelines all state that the Operator must, in its transactions with Related Parties, determine its income, costs, expenses and investments considering the prices and consideration that would have been used with or between unrelated parties in comparable transactions, under the terms, methods and conditions set forth in the MITL, i.e., that that are at arm’s length.
Procurement of Goods and Services – Procurement Guidelines
With respect to the Guidelines for goods and services procurement, MC1 provides that the contracting of suppliers should consider the enterprise offering the best quality and price for the volumes of goods and services required throughout the project, and that the contracting or acquisition of such goods and services should be done at market values. On the other hand, MC2 provides additional criteria under which such procurement should be considered—in addition to the best price and quality, logistics and warranties for the volumes of goods and services—supplying any documentation demonstrating that the contracting of such goods and/or services was not above the benchmarks or Market Prices. In addition, according to MC2, the procurement of goods should abide by principles of transparency, economy and efficiency, under criteria consistent with numeral 31 of the SHCP Guidelines.
Furthermore, in line with the provisions of numeral 32 of the Guidelines, requirements are added to MC2 for acquisitions and contracting by the Contractor in the context of the execution of the Contract. These requirements consist of (i) minimum National Content parameters, and (ii) preferential contracting and acquisitions of local source companies and goods, of respectively, provided that they are deemed similar in quality and availability to those in the international market, and their prices are within the benchmarks or Market Prices.
It should be noted that, according to the additions to MC2 and the provisions of numeral 35 of the Guidelines, the tender or bidding procedures carried out by Contractors should not establish requirements that impede or hinder the participation of enterprises or that undermine the level playing field for bidders.
As regards the contracting of goods and services suppliers, MC1, MC2 and the Guidelines each establish a different contracting according to the different contract or acquisition amounts:
- Contracts or acquisitions with a value less than or equal to $1,000,000 USD. MC1 provides that the contractor may execute the contract with the subcontractor and/or supplier it deems best qualified, without having to hold a tender, and must keep supporting documentation showing that the contract met the arm’s length standard. In this sense, while MC2 continues to accord certain freedom to the Contractor to contract this type of goods and services, with the amendments to MC2 and consistent with the Guidelines (numeral 35), more specific requirements are provided, stating that the Operator must keep the information, documentation and/or evidence demonstrating that those subcontracts or acquisitions held with Related Parties were determined considering the arm’s length principle. In the case of transactions with third parties subject to regional or global agreements, the Operator must keep the information, documentation and/or evidence that such transactions were carried out under market benchmarks and, as applicable, the benefits derived from such contracts are reflected as lower recoverable costs.
- Contracts or acquisitions with a value of more than $1,000,000 USD and less than or equal to $20,000,000 USD. Under MC1, when selecting the supplier, the contractor must have at least 10 quotes considering at least 3 domestic companies, provided that they exist. For this type of procedure, if the value of the chosen quote is 5% higher than the lowest price found among market values, the contractor had to justify the reason for its choice. Moreover, in the case that the chosen supplier was a related party of the contractor, the contractor had to submit the respective transaction contract and the transfer pricing study to the SHCP and the CNH.
In this regard, the contracting criteria are very similar to those in MC1, except that rather than using the term “market values”, reference is made to “benchmarks or Market Prices” and the concepts formally defined in the Guidelines, such Related Parties and Transfer Pricing Study.
- Contracts or acquisitions with a value of more than $20,000,000 USD. In this type of contracts, MC1 provides that the Contractor must hold an International Public Tender and provide the contract and corresponding tender report to the SHCP, showing that the transaction is at market values regardless of the proposal chosen. MC2 and the Guidelines do not require that the transaction be demonstrated to be at market values.
Procurement of Goods and Services – Direct Assignment to Related and Unrelated Parties
An important change in MC2 and the Guidelines with respect to MC1, regarding the direct assignment of contracts, is that MC2 exempt contractors from undertaking the aforesaid contracting procedure in the case of related-party transactions, provided that the parties demonstrate, before the assignment, that the transaction meets the arm’s length standard. MC2 and the Guidelines allow the possibility of direct assignments with unrelated third parties as well, under the same terms. In either case, when the value of the transaction is found to be above the benchmarks or Market Prices, the difference will be deemed non-recoverable.
Non-Recoverable Costs, Expenses and investments
In particular, in addition to the non-recoverable cost, expense and investment items included in MC1, MC2 and the Guidelines indicate that costs, expenses and investments incurred for the following items cannot be deemed recoverable:
- Negligence, fraud, willful misconduct, bad faith or fault of the Operator, its subcontractors or their respective affiliates;
- Any gift or donation;
- Costs and expenses derived from the failure to comply with the applicable standards and best industry practices, including risk management;
- Commissions paid to agents or commissionaires;
- Those not strictly indispensable for the activity set forth in the contract; and
- Costs, expenses and investments above the benchmarks or Market Prices, as indicated in numerals 1.19 of Exhibit 4 and numeral 1.5 of Exhibit 11 of MC2, with respect to procurement activities.