Energy, Mining and Infrastructure
Legal Alert August, 2014
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Mexico’s Energy Reform
Hydrocarbons Revenue Law
On August 11th 2014, a Decree promulgating the Hydrocarbons Revenue Law (the “HRL”) was published in the Official Federal Gazette, as part of a legislative package containing a series of amendments to the Federal Fees Law and the Fiscal Coordination Law for consideration by the Mexican Congress, in line with the energy reforms enacted under the recent constitutional amendments.
The purpose of the HRL is to establish the regime applicable to the revenue obtained by the Mexican State from contracts executed with private parties or from direct assignments to PEMEX to carry out the exploration and extraction of hydrocarbons, and to regulate the management and oversight of the financial aspects of such contracts.
The Law enters into force on the date following its publication, except for the provisions establishing the fiscal regime applicable to PEMEX assignments, which will become effective on January 1st 2015.
The Law establishes the concepts and mechanisms whereby the Mexican State is to obtain revenue from hydrocarbon exploration and extraction activities, resulting from contracts models to be executed with private enterprises or assignments to state-owned enterprises (such as PEMEX).
In addition to establishing a detailed regime for the revenue to be received by the Mexican State, the HRL specifically provides the tax obligations applicable to contractors and/or assignees under the Income Tax Law and other laws.
While the tax regime for state-owned enterprises is of major importance in the national context, this alert summarizes key issues for the private sector interested in hydrocarbon exploration and extraction through contracts to be executed with the Mexican State.
What the HRL States Scope of hydrocarbon exploration and extraction activities
The HRL provides the main concepts from which the Mexican State will obtain revenue from hydrocarbon exploration and extraction, defined as those activities specifically set forth in the Hydrocarbons Law, including the
construction, location, operation, use, abandonment and winding up of facilities for the production, treatment and refining of oil and the processing of natural gas.
Income from exploration and extraction activities
In accordance with the new forms of hydrocarbon exploration and extraction contracting under the Mexican Constitution, the Law provides that the Mexican State may execute the following types of agreements with private enterprises for hydrocarbon exploration and extraction:
1. Licensing agreements;
2. Profit sharing agreements;
3. Production sharing agreements; and
4. Service agreements.
In this context, the Mexican State may derive revenue from the consideration payable under each agreement (in addition to the fees for assignments with state-owned companies). The consideration and fees will be payable to the Mexican Oil Fund according to the mechanisms provided in the HRL, in each contract, or in other applicable provisions.
In general, hydrocarbon exploration and extraction agreements establish considerations corresponding to the State and private parties. The following table summarizes the considerations applicable to each agreement:
As seen above, only licensing and production sharing agreements allow the contractor to take ownership of all or part of hydrocarbon production for its own marketing and to recover its investment accordingly. Under other agreement models, the contractor will receive payment in cash directly from the Mexican Oil Fund, and the hydrocarbons will be owned by the State, to be marketed for its benefit by a designated marketer.
In the case of licensing agreements, ownership of hydrocarbons is transferred for consideration once they are extracted from the subsoil, as long as the contractor is current in the performance of its obligations under the agreement. Under production sharing agreements, contractor will take ownership of the hydrocarbons in the proportion representing the consideration owed by the Mexican State, i.e., recoverable costs plus a part of
the operating profit.
On the other hand, in profit sharing agreements, contractor will receive the entire consideration in cash and will not own the extracted hydrocarbons at any time. This consideration will be equal to the recoverable costs plus the remainder of operating profit.
Lastly, under service agreements, overall production is handed over to the State and the contractor will receive consideration in cash. The type of consideration is not specified, but will be established in line with regard to industry standards or practices.
The consideration payable to the State includes:
1. An agreement signing bonus, amount and conditions of which will be included in the public tender. The bonus must be paid in cash;
2. A monthly contractual fee for the exploratory phase, also payable in cash, to be calculated as follows:
• $1,150 pesos per square kilometer during the first 60 months of the agreement term;
• $2,750 pesos per square kilometer as from the 61st month of the agreement term.
3. A royalty to be calculated according to the type of hydrocarbon, with regard to its contractual value. The base amount for oil is $48 dollars per barrel, subject to adjustment for inflation. If the price is below $48 dollars, the applicable royalty rate will be 7.5%; if the price is equal to or greater than $48 dollars, a factor based on the contractual oil price will be taken to calculate the royalty rate.
4. Consideration to be determined in the agreements, applying a rate to the contractual hydrocarbon value, which may be modified with certain adjustment mechanisms to be included in the contracts and public tenders.
The consideration payable to the contractor will be the onerous transfer of the hydrocarbon once extracted from the subsoil, provided that the contractor is current in the performance of its obligations with the State.
Profit Sharing and Production Sharing Agreements
Under profit and production sharing agreements, the HRL provides the following consideration payable to the Mexican State:
1. Contractual fee for the exploratory phase, to be calculated on the same basis as the licensing agreement.1
2. Royalties to be determined using the same procedure discussed for licensing agreements.
3. A consideration to be determined by applying a percentage to the operating profit.
The HRL provides, as consideration payable to contractors, the recovery of investments, costs and expenses recognized according to the guidelines issued for such purpose by the Ministry of Finance and Public Credit, plus a percent share of operating profit. Under a production sharing model, the contractor will receive its consideration in kind through the delivery of hydrocarbons, while the profit sharing model provides for consideration in cash.
In a production sharing contract, it may be elected to not include cost recovery as part of the contractor’s consideration. In this case, the only consideration payable to the contractor, in kind, is a share of the operating profit.
For purposes of these agreements, the HRL provides how operating profit is will be determined, i.e., the contractual value of the hydrocarbons less the amount of royalties and recoverable costs.
For purposes of determining recoverable costs, the HRL provides that non-deductible items include financial costs, expenses associated with the failure to comply with the applicable rules, royalty payments (except when there is a transfer pricing study), legal costs in any arbitration or dispute, or all costs, expenses or investments corresponding to other contracts.
The consideration is payable to the contractor in cash, at market prices, out of the Mexican Oil Fund.
Entities that may be Contractors
Under the HRL, only state-owned enterprises or entities created under Mexican law that are residents for tax purposes in Mexico, whose sole corporate purpose is hydrocarbon exploration and extraction, and which are not taxed under the special integration regime in the Income Tax Law, may be contractors, pursuant to the Hydrocarbons Law. Therefore, companies residing outside Mexico for tax purposes, whether because they were created under foreign law or are vehicles whose principal place of business or place of effective management is outside national territory, may not be contractors.
State-owned enterprises and entities may participate on an individual basis, through a consortium or joint venture.
A joint venture agreement is essentially an agreement with no legal standing per se, but which is treated as a taxpayer for income tax purposes, where its members are treated as shareholders. Joint ventures must also be undertaken pursuant to Mexican law. In both a joint venture and consortium, the parties must be Mexican tax residents and meet all other applicable fiscal requirements.
Fiscal Aspects of the HRL
The HRL does not contemplate a special tax regime for contractors, which will be subject to the income tax, value added tax (“VAT”) and other taxes under applicable laws, like any other corporate taxpayer. However, there are certain special provisions for contractors for income tax and VAT purposes. A new tax is also created solely with respect to contractors, as discussed below.
The HRL allows a contractor to have more than one agreement. Thus, if the same entity acts as contractor under two or more contracts, profits and losses generated in such agreements may be “consolidated” for purposes of determining taxable income for income tax purposes.
Tax Losses from Deep-Water Projects
Under the Income Tax Law, tax losses may be carried forward for up to 10 years. However, taxpayers engaged in activities in marine regions whose depth is more than 500 meters, may carry forward tax losses for up to 15 years, until they are depleted. Whether the 15-year tax loss carry forward term is applicable to profits from onshore or shallow water projects (less than 500 meters) should be evaluated.
Depreciation Rates under the Law
In lieu of applying the depreciation rates set forth in Articles 33 and 34 of the Income Tax Law, contractors should apply the rates provided in Article 32 of the Law, as follows:
A. 100% of the original amount of investments for exploration, secondary and improved recovery, and non- capitalized maintenance in the year in which made;
B. 25% of the original amount of investments for the development and exploitation of oil or gas deposits, each tax year; and
C. 10% of the original amount of investments in storage infrastructure and transportation as needed for contract performance, such as the oil and gas pipelines, terminals, transportation or storage tanks necessary to convey the Contractual Production to the delivery, metering or inspection points determined in each contract, every tax year.
The HRL is worded so that these rates are mandatory, and the rates under the Income Tax Law cannot be used. It should be analyzed whether lower rates may be used under the prescribed election.
The HRL provides that exploration and extraction activities are zero rated for VAT purposes. The 0% rates only applies to agreements between the Mexican State and state-owned enterprises or entities, and do not apply to any other agreement executed with third parties, even in the case of exploration and extraction contracts.
Special Permanent Establishment Regime
In our view, the HRL exceeds the commitments assumed by the Mexican
authority with its main trading partners under their double tax agreements. In general, a permanent establishment may be created when construction activities (or related activities) are carried on, when such services are rendered for more than six months. Under the HRL, a permanent establishment is deemed to exist when a foreigner engages in the activities referenced in the Hydrocarbons Law in national territory or in the exclusive economic zone for more than 30 days in any period of 12 months. This provision does not affect contractors because, as mentioned, they are already deemed Mexican tax residents; rather, the impact will be felt by subcontractors. Note also that, under the Income Tax Law, non-residents who receive wages, salaries and similar compensation paid by non-residents without a permanent establishment in the country are exempt for the first 183 days of service (or their physical presence) in national territory. Under the HRL, this exemption is limited to 30 days in the case of employment associated with exploration and extraction activities.
Contractors that execute exploration and extraction contracts under the HRL must pay 10% of profits to their employees. The new subcontracting provisions should be analyzed with respect to outsourced service providers, to determine whether this profit sharing obligation applies to the corresponding companies.
New Tax on Hydrocarbon Exploration and Extraction Activities
A new tax is created to be levied on contractors and assignees as a fee payable per square kilometer of assigned area as follows: $1,500 pesos during the exploration phase and $6,000 pesos during the extraction phase. The tax is to be paid on a monthly basis.
Consortium Tax Regime
The HRL establishes a new tax regime for entities involved in agreements through a consortium. This regime enables each member of the consortium to directly recognize project income and costs as a function of their percent share, whereby each party is taxed individually for income tax purposes. For these purposes, one of the parties will be named as operator, with a series of formal reporting obligations and other requirements relating to the issuance and receipt of tax invoices.
The transfer pricing rules under the Income Tax Law apply to contractors’ related-party transactions, for tax purposes and for purposes of determining the operating profit in the profit and production sharing contracts.
Aspects to Consider
• A financial analysis should be conducted considering the different consideration payable under the agreements, with regard to the potentially non-deductible costs and expenses associated with the operating profit.
• An analysis should be performed on the amount of value added tax that may be recovered with respect to the VAT to be charged and/or
paid on the activities undertaken with the third parties involved in the exploration and extraction agreements.
•The best corporate structure to hold the operating company acting ascontractor under the Law should be determined.
•A detailed financial and legal analysis should be performed, todetermine the scope and application of the depreciation rates underthe Law and analyze the convenience of applying a 15-year tax losscarry forward term in the case of deep-water exploration andextraction contracts (more than 500 meters).
•A labor analysis should be carried out to determine the scope of thesubcontracting rules in light of the non-inclusion of the profit sharingexemption under the Decree.
ConclusionThe HRL and all other laws associated with the energy reform, will shift a number of paradigms in Mexico’s energy industry. A detailed analysis is necessary to understand the potential financial and tax implications that may arise from contracts executed under the Law. We will be happy to answer any questions regarding the HRL.
ContactsBenjamin Torres Barron [email protected] Jorge Guadarrama Yañez [email protected] Luis Carbajo Martinez [email protected] Carlos Alberto Linares-Garcia [email protected] Hector Reyes Freaner [email protected] Jose M. Larroque [email protected] Federico Ruanova Guinea [email protected] Juan Carlos Valles Zavala [email protected] Eduardo Romero Ramos [email protected]
Alejandro Sepulveda [email protected] Gaspar Gutierrez Centeno [email protected] Juan Bernardo Garcia Garza [email protected] Jorge L. Ruiz [email protected] Fabian Monsalve Agraz [email protected] Reynaldo Vizcarra Mendez [email protected] Edmundo Elias Fernandez [email protected] Manuel Padron Castillo [email protected] Adriana Ibarra Fernandez [email protected]
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