On April 30, 2014, the Federal Government of Mexico submitted to the Mexican Senate, through the Secretary of the Interior, a package enclosing the bills to issue new laws as well as amendments to existing laws, which will serve to implement and regulate the constitutional energy reform published on December 20, 2013. Such package of bills contemplates the issuance of 9 new laws, as well as the reform, addition to, and/or repeal of several provisions related to 12 existing laws.
Under the constitutional reform mentioned above, some of the types of contracts shall be: services, profit sharing, production sharing, or license, to carry out the exploration and extraction activities for oil and for liquid, gaseous, and solid hydrocarbons on behalf of the Nation, including those activities that the Production Companies of the State can carry out with private individuals (hereinafter the "Contracts").
The compensation regime applicable to the new types of Contracts and direct awards established in the constitutional reform dated December 20, 2013 is contained in the proposed Hydrocarbons Revenue Law ("LISH" for its acronym in Spanish). This bulletin addresses the proposed compensation regime for the Mexican State in connection with the exploration and extraction activities conducted through the new type of Contracts, as well as the tax aspects that are more relevant to contractors.
The purpose of the LISH Bill is to establish:
- The compensation regime for the revenues that the State will receive as a result of the hydrocarbon exploration and extraction activities to be conducted through the direct awards and Contracts referred to in Article 27 §7 of the Constitution and in the Hydrocarbon Law, as well as the rate of considerations to be set forth in the Contracts;
- The legal provisions related to the management and supervision of the financial aspects of the Contracts; and
- The obligations on transparency and accountability regarding the resources referred to in the LISH Bill.
The most relevant tax and financial aspects included in the LISH Bill are:
- Ring-fencing: The bidding terms of the Contracts and the Contracts themselves must specify that only the Production Companies of the State, legal entities, or joint ventures (asociaciones en participación) whose purpose is exclusively the exploration and extraction of hydrocarbons and related activities will be entitled to take part in the bidding processes for the awarding of each Contract. For such purposes, said entities cannot pay taxes under the optional tax regime established in the Mexican Income Tax Law (MITL) (Integration Regime) for group of companies that are referred to in Chapter VI of Title II of the MITL. Moreover, such entities cannot participate in more than one Contract, except for the cases where the Contractor is a Production Company of the Sate. It is important to consider that the proposed Hydrocarbons Law sets forth that the legal entities subject to the contract regime are commercial companies incorporated pursuant to the Mexican law, and that the joint ventures will be deemed legal entities for such purposes.
- Permanent Establishment: For purposes of the LISH Bill and the MITL, a permanent establishment will exist when an entity residing abroad carries out the activities referred to in the Hydrocarbon Law in national territory or in the Mexican exclusive economic zone for a period adding to more than 30 days in a 12-month term.
- Depreciation schemes: To determine the deduction of investments for hydrocarbons development projects, instead of applying the deduction percentages established in Articles 33 and 34 of the MITL, Article 32 of the LISH Bill establishes specific percentages.
- Adjustment mechanism: The rates applicable to the Operating Profit or the value of hydrocarbons in order to calculate the consideration amount that a Contractor will pay to the State, depending on the contract in question, will be modified through an adjustment mechanism that will be included in the bidding terms for its awarding or in the Contracts derived from a migration (applicable for the migration of PEMEX taxation to the new regime of Contracts).
- Employees' profit sharing: The profit of Contractors and assignees will not be shared among their employees, without prejudice to the fact that, according to the labor law, they may grant their employees any incentive, compensation, bonus, reward, or commission for carrying out their duties.
- Limitation on total deductions per period: For calculating the operating profit, exclusively for the determination of the considerations to be paid to the State or Contractor, it is proposed to establish a limit on the applicable total deductions per period. Those investments that, being deductible, exceed the limit of applicable costs in the period may be transferred to subsequent periods.
- Loss carry forward: Another element that is included for the different types of Contracts is the possibility to carry losses forward for up to ten fiscal years for purposes of determining the effects on the calculation of considerations.
- Transfer pricing: In cases where the Contractor carries out transactions with related parties for the sale or marketing of hydrocarbons as well as the procurement of inputs, materials, or services, it is established that the Transfer Pricing Guidelines approved by the Organization for Economic Co-operation and Development in 1995, or those that may replace them, will be applicable to the extent they are consistent with the provisions proposed in the LISH Bill, the Mexican Income Tax Law (MITL), and the international treaties executed by Mexico.
Below please find a summary of the main contractual and tax conditions that will regulate the various types of Contracts included in the proposed LISH Bill.
1. License Contracts
- As to License Contracts, Article 6 establishes the following considerations:
A. In favor of the State:
a. A signing bonus, which will be determined by the Ministry of Finance and Public Credit ("SHCP"); the signing bonus will be included in the bidding terms for Contract awarding or in the Contracts derived from a migration, and the bonus will be paid in cash by Contractor to the State through the Mexican Oil Fund (Fondo Mexicano del Petróleo).
In addition, the following considerations will be paid in cash by Contractor to the State in each period, and as established in the provisions of the corresponding Contract:
b. Contractual Fee for the Exploratory Phase;
c. The Royalties determined pursuant to Article 24 of the LISH Bill, and
d. A consideration that will be determined in the Contracts, taking into account the application of a rate to
i. The Operating Profit, which will be determined each period and will be the result of reducing from contractual value of the hydrocarbons
- (i) the amount of the royalties actually paid by Contractor in the period; and
- (ii) the costs and expenses incurred in the period, as well as the proportional part of the investments required for the contract execution, taking as reference the items and percentages referred to in the MITL; or
ii. The Hydrocarbons Contractual Value.
B. In favor of Contractor, the onerous transfer of hydrocarbons, once they have been extracted from the subsoil, provided that the considerations indicated in paragraph A above are covered in the terms of the Contract.
- In accordance with Article 12 of the Bill, to calculate the deduction of investments, instead of applying the deduction percentages established in Articles 33 and 34 of the MITL, the following percentages shall apply:
A. 100% of the original investments made for exploration, secondary and enhanced recovery, and the non-capitalized maintenance in the fiscal year where they are made;
B. 25% of the original amount of investments made for the development and exploitation of oil and natural gas fields, in each fiscal year; and,
C. 10% of the original amount of investments made in storage and transportation infrastructure that is indispensable for the performance of the Contract, such as oil pipelines, gas pipelines, terminals, storage transportation or tanks that are necessary to take the Contractual Production to the delivery, measurement or taxation points determined in each Contract, in each fiscal year.
- Costs, expenses and deductions corresponding to investments exceeding the Hydrocarbons Contractual Value reduced from the Royalties actually paid may be deducted in the 10 fiscal years following the corresponding fiscal year accordingly to the guidelines issued by SHCP. However, such deduction may not be applied in another Contract.
- In order to establish the costs and expenses that will be considered for determining the Operating Profit mentioned above, the following items cannot be deducted:
A. Financial costs;
B. Costs incurred due to the negligence or fraud of Contractor or of the persons acting on her behalf;
D. Costs and expenses for easements, rights-of-way, temporary or permanent occupations, leases or acquisitions of land, and any other analogous concept;
E. Costs incurred for advisory services, except for those provided for in the guidelines issued by SHCP;
F. Expenses derived from any failure to comply with the applicable norms and standards, including risk management standards;
G. Expenses related to the training and training programs that do not meet the guidelines issued by SHCP;
H. Expenses derived from failing to comply with warranty conditions, as well as those resulting from the acquisition of goods that do not have a warranty from the manufacturer or its representative against defects in workmanship in accordance with the practices generally used in the oil and gas industry;
I. Expenses, costs and investments for the use of their own technologies, except for those documented through a transfer pricing study in terms of the applicable law;
J. Amounts recorded as provisions and fund reserves, except for those for the abandonment of facilities pursuant to the guidelines to be issued by SHCP;
K. Legal costs for any arbitration or dispute involving Contractor;
L. Commissions paid to brokers;
M. Payments for royalties and Contractual Fees for the Exploratory Phase; and
N. Any other specified in each Contract depending on any specific circumstances and situations, and those to be established in the guidelines that may be issued by SHCP for such purposes.
2. Profit Sharing and Production Sharing Agreements
- As to the Profit Sharing and Production Sharing Agreements, Article 14 of the LISH Bill sets forth the following considerations:
A. In favor of the Mexican State:
a. Contractual Fee for the Exploratory Phase;
b. The Royalties determined pursuant to Article 24 of the Bill (included below), and
c. A Consideration to be determined through the application of a percentage to the Operating Profit; and
B. In favor of Contractor:
a. The recovery of costs, subject to the provisions of Article 19 of the Bill, and
b. A Consideration that will be the remaining Operating Profit after covering the Consideration in favor of the State, as stipulated in paragraph c) of Section A above.
- Contractors operating under the Profit Sharing modality must deliver the total contractual production to a trader, which will be a legal entity selected by the National Hydrocarbons Commission through a bidding process and per request of the Mexican Oil Fund, which in turn will deliver the revenues from the commercialization of hydrocarbons to such Fund. The latter will keep the considerations corresponding to the State and will give the Contractor those corresponding to the same, if any, for every period as indicated in the agreement.
- Unlike the foregoing, in the case of Production Sharing Agreements, the considerations will be paid to Contractor in kind, that is, as a proportional part of the Hydrocarbon production that is equal to the value of such considerations. Moreover, the State will determine, in the Contract, those considerations that contractor must give in kind to the trader, who, in turn, will deliver to the Mexican Oil Fund the proceedings from the commercialization in each period.
- In connection with the recovery of costs, they will be in an amount equal to the costs, expenses and investments acknowledged pursuant to the guidelines to be issued by SHCP to that end. In each Period, this Consideration shall not be greater than the Cost Recovery Limit. Moreover, the costs, expenses and investments acknowledged that are not paid out of the consideration corresponding to the cost recovery as a consequence of the application of the Cost Recovery Limit in the period in question, will be transferred to be included in the consideration corresponding to the cost recovery for subsequent periods. It is important to mention that is not possible to acknowledge or record the items indicated as non-deductible in the procedure for the calculation of the Operating Profit of License contracts.
- Finally, under Article 20 of the Bill, the Operating Profit derived from the Contract will be determined for each Period by subtracting the following from the Contractual Hydrocarbons Value for the period:
A. The amount of Royalties generated in the period, and
B. The consideration corresponding to the cost recovery as determined in accordance with Article 19 of the LISH Bill.
3. Service Contracts
- In the case of Service Contracts for Hydrocarbon Exploration and Extraction, Article 21 of the Bill indicates that Contractors will deliver the entire Contractual Production to the State, and the considerations in favor of Contractor will always be in cash and will be set forth in each Contract, considering the industry standards or uses. Such considerations shall be covered by the Mexican Oil Fund out of the resources generated by the commercialization of the contractual production that may derive from each Service Contract.
Common Provisions regarding Considerations
- Section four of Title II of the LISH Bill establishes, in Articles 23 through 25, Common Provisions regarding considerations, applicable to all Contract modalities, except for Service Contracts.
- The Contracts will contemplate a monthly payment in favor of the Mexican State for the Contractual Fee for the Exploratory Phase, on the portion of the Contractual Area that is not involved in the production phase at the time, in accordance with the following fees:
A. During the first 60 months of the Contract effective term, $2,650 pesos per square kilometer will be paid;
B. As of month 61 of the Contract effective term, $4,250 pesos per square kilometer will be paid on a monthly basis.
The monthly fees contemplated herein will be updated in the month of January of every year, in accordance with the variation of the National Consumer Price Index for the preceding year.
- In addition, under Article 24 of the Bill, Contracts shall consider for every period an amount of considerations named Royalties to be paid in favor of the Mexican State, the amount of which will be determined per type of hydrocarbon by applying the corresponding rate (as determined in accordance with sections I – III of the same Article 24), to the Oil Contractual Value, the Natural Gas Contractual Value and the Condensates Contractual Value, as follows:
A. The following rate will be applied to the Oil Contractual Value:
a. When the Oil Contractual Price is less than 60 US dollars per barrel, a rate of 5%, and
b. When the Oil Contractual Price is greater than or equal to 60 US dollars per barrel:
Rate = [ (0.125 x Oil Contractual Price) – 2.5 ] %
B. The following rate will be applied to the Natural Gas Contractual Value:
a. In the case of Associated Natural Gas:
Click here to view table.
b. In the case of Non-Associated Natural Gas:
i. When the Natural Gas Contractual Value is less than or equal to 5 US dollars per one million of BTUs, a rate of 0%;
ii. When the Natural Gas Contractual Value is greater than 5 and less than 5.5 US dollars per one million of BTUs:
Click here to view table.
ii. When the Contractual Price of Natural Gas is greater than or equal to 5.5 US dollars per one million of BTUs:
Click here to view table.
C. The following rate will be applied to the Condensates Contractual Value:
a. When the Condensates Contractual Value is less than 60 US dollars per barrel, a rate of 5%, and
b. When the Condensates Contractual Value is greater than or equal to 60 US dollars per barrel:
Rate = [ (0.125 x Condensates Contractual Value) – 2.5 ] %
- In determining the rates for the calculation of the Royalties contemplated in Article 24 of the LISH bill, the effects of the variations in the US Producer Price Index or the index that may replace it must be taken into consideration. To do so, SHCP will be subject to the guidelines that may be issued to that end, which will be published by the Federal Official Gazette.
- Moreover, the Contracts will provide that, for each period, the Hydrocarbons Contractual Value will be determined, and that each Contract shall include the mechanics to determine the contractual values of oil, natural gas and condensates.
- Likewise, the LISH Bill provides that every license Contract, profit sharing Contract and production sharing Contract should contain a formula or adjustment mechanism that, starting from the profitability of each period, increase the considerations in favor of the Mexican State by amending any of the parameters that determine the Contractual considerations.
Transactions with Related Parties
- In the case of transactions between related parties, pursuant to the provisions of Article 30 of the LISH Bill, in transactions dealing with the sale or commercialization of Hydrocarbons as well as with the procurement of supplies, materials or services, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, as approved by the OECD Council and effective to this date shall apply, provided that they are consistent with the provisions of the LISH Bill, the MITL and the Treaties to which Mexico is a party.
- Furthermore, in order to determine the Operating Profit of license Contracts, the LISH Bill provides that the expenses, costs and investments made for the use of their own technologies shall not be deductible, except for those that have a transfer pricing study in place in terms of the applicable legislation.
Provisions Applicable to Contracts
- Chapter II of the LISH Bill, in Article 26, sets forth that SHCP shall determine, with prior opinion of the Ministry of Energy, the economic conditions relating to the fiscal terms contained in the LISH Bill that should be included in the bidding terms for awarding Contracts.
- The variable regarding the awarding of Contracts will be, in all instances, one single variable of an economic nature, always aiming at maximizing revenue in order to obtain the greatest benefit for long-term development. Considering the particular circumstances of each Contract, SHCP may set a minimum value acceptable to the State for the awarding variable.
- SHCP may choose to include, in any Contract, any of the considerations indicated in this Law or a combination of the same.
- Article 29 of the Bill sets forth that the considerations in favor of Contractor will be paid once the Contractor obtains the Contractual Production. Therefore, as long as there is no Contractual Production, under no circumstances can the considerations in favor of Contractor be demanded, nor can any advance payment whatsoever be made to him.
- In addition, the Bill sets forth that the bidding rules for Contracts and the Contracts themselves must specify that only State's production companies, legal entities, or joint ventures (asociaciones en participación) may be allowed to participate in bidding processes for the awarding of Contracts, provided that their purpose is exclusively the exploration and extraction of hydrocarbons and related activities. For such purposes, said entities cannot pay taxes under the optional tax regime established in the MITL (Integration Regime) for group of companies that are referred to in Chapter VI of Title II of the MITL. Moreover, such entities cannot participate in more than one Contract, except for the cases where the Contractor is a Production Company of the Sate.
Deduction Percentages for the Calculation of Income Tax
- For the calculation of the Income Tax, instead of using the deduction percentages set forth in Articles 33 and 34 of the MITL, Contractors must apply the percentages shown below, as indicated in Article 32 of the Bill.
A. 100% of the original amounts of investments made in exploration, secondary enhanced recovery and non-capitalized maintenance, in the fiscal year in which they are carried out;
B. 25% of the original amounts of investments made in the development and exploitation of oil or natural gas fields, in each fiscal year, and
C. 10% of the original amounts of investments made in the infrastructure of storage and transport indispensable for the performance of the Contract, such as oil and gas pipelines, terminals, transport or storage tanks needed for taking the Contractual Production to the points of delivery, measurement, or supervision and control determined for each Contract, in each fiscal year.
- Finally, where there is the intent to execute Contracts different than those indicated in the LISH Bill, SHCP will determine the corresponding considerations from among those contemplated in the law or a combination of the same, always aiming at maximizing the Nation's revenues.
Functions of SHCP
- SHCP will perform the functions referred to in Title Two of the Bill and all the others contemplated in the applicable provisions and the Contracts, in accordance with the guidelines to be issued, if any.
- It is important to emphasize that, in exercising the functions indicated in the preceding paragraph, SHCP will not be considered an authority. Therefore, no administrative or judicial appeal whatsoever will be admissible against its rulings, which can be questioned only in the manner and terms indicated in the Contracts.
- SHCP will perform the following functions, among others:
A. Determine the bases and rules for the registration of costs, expenses and investments under the Contract, in accordance with the guidelines to be issued to that end. Such bases and rules shall be included in the respective Contract;
B. Determine the bases and rules for the procurement of goods and services needed for the activities carried out under each Contract, the purpose of which shall be to minimize costs, expenses and investments, favoring always the use of mechanisms guaranteeing the greatest transparency and competition in the Contractor hiring processes. Such bases and rules shall be included in the respective Contract;
C. Receive from Contractors the information and documentation related to the costs, expenses and investments, as well as to the deduction of such investments, as required for the execution of the Contract, and to keep a record of such items and, as applicable, to acknowledge the same;
D. Verify the correct payment of Royalties and Contractual Fees for the Exploration Phase as set forth in the Contract;
E. Keep the information records required for the calculation of the considerations set forth in the Contract and to carry out the other functions it must assume;
F. Instruct the Mexican Oil Fund of the payment to Contractors of any considerations corresponding to them under the Contract, as applicable;
G. Verify the operations and accounting records derived from the Contract, even by conducting audits or inspections to Contractors, in accordance with the guidelines issued to that end;
H. Request from Contractors and third parties for any information required for the correct performance of its functions, as set forth in the Contract;
I. Request from the National Hydrocarbons Commission for technical support and the conduction of field or any other kind of inspections to verify the Contractors' activities and investments, and
J. Give notice to the National Hydrocarbons Commission regarding any irregularities that may be detected in the performance of the Contract, in order to enforce the rights corresponding to the State under the Contract, or to apply the penalties or sanctions contemplated in the Contract. The foregoing shall apply without prejudice to any other legal, judicial, or criminal actions that may be applicable.
- The profits of Contractors and Assignees shall not be shared with their workers. The foregoing shall apply without prejudice to the fact that, under the labor legislation, they can grant their workers any kind of incentive, compensation, bonus, reward, or commission for the performance of their duties.
- For purposes of the LISH Bill as well as of the MITL, a permanent establishment is considered to be constituted when a foreign resident carries out the activities referred to in the Hydrocarbons Law in the Mexican territory or in Mexico's exclusive economic zone, during a term amounting in the aggregate over 30 days within any given 12-month term.
- For purposes of computation of the period for creating a permanent establishment, it will include all the activities conducted by a related party of the foreign resident, provided that such activities are identical or similar, or are part of the same project. Related parties are those indicated in Article 179 of the MITL.
The proposed LISH Bill contains a series of novel concepts in the Mexican legislation with respect to the mechanisms through which the Mexican State will receive revenues from the activities of hydrocarbon exploration and extraction, under the new constitutional regime of the energy sector.
It is important to analyze and understand the effects of the proposed provisions in order to make an adequate financial and economic evaluation for the eventual exploration and extraction projects in Mexico. Furthermore, it is advisable to closely follow the legislative process with respect to the discussion and approval of this law, in order to identify any possible changes that might have a considerable impact in the structures or Contracts being proposed.