Mexican energy legislation

Mexico has initiated sweeping reforms to liberalize its energy sector. As Mexico welcomes foreign investment, there will be cross-border tax consequences for US investors entering into production sharing, profit sharing, and service agreements, as well as licenses and joint ventures with Pemex. The new legislation is in draft form, and is currently under debate in an extraordinary session of the Mexican Congress. It is likely that any future framework will include certain key features that will govern foreign investment in the Mexican energy sector. First, the reforms will affect not only oil and gas but also the electric power industry. Second, Pemex will be converted into a "productive state company" and allowed to enter into joint ventures with foreign companies to exploit its oil and gas fields. Third, with respect to the oil and gas fields that Pemex chooses not to pursue, foreign oil and gas companies will be allowed to bid to exclusively develop and produce the fields in exchange for providing the government with certain economic benefits.

As of the end of July, 2014, the Mexican Senate had sent four energy bills to the lower house of Congress for further debate and approval. The lower house of Congress, responsible for initiating revenue bills, was also debating the Hydrocarbons Revenue Tax Act. It is anticipated that the energy reform laws will be sent to the President's office in August or September for his signature.

Steps to liberalize the oil and gas industry

On March 21, 2014, Pemex submitted to the Ministry of Energy ("SENER") its "Round Zero" request, which included (i) 100% of current producing areas; (ii) 83% of proven and probable reserves; and (iii) 31% of prospective resources. SENER has until September 17, 2014, to resolve which of those areas will be granted to Pemex under the "asignaciones" regime, allowing Pemex to explore and produce hydrocarbons in such areas. Pemex may request the approval from SENER to migrate the "asignación" to an E&P contract, allowing associations and alliances with private parties.

The fields that are not awarded to Pemex through "asignaciones" will be put up for auction to third-parties. The Mexican National Hydrocarbons Commission ("CNH") will enter into four different types of contracts to develop the fields: (i) service contracts; (ii) profit sharing contracts; (iii) production sharing contracts; and, (iv) licenses. It should be noted that under the Constitution, the government of Mexico is precluded from awarding concessions which convey title to the minerals in the ground. In order to ensure that at least a percentage of future profits inure to the benefit of the Mexican people, Mexico will set up a petroleum fund for stabilization and development (petroleum fund). All payments to this petroleum fund or any other agency of the state will be referred to as payments to the government of Mexico.

General taxation of investors

All corporations and companies doing business in the Mexican energy sector will be subject to the Mexican corporate income tax (CIT). Mexico does not have a tax transparent entity such as the partnership. It can also be assumed that each company or corporation will become subject to the Mexican value added tax (VAT).

Any oil field service company which performs work in Mexico for a period exceeding 30 days in any twelve month period becomes subject to the CIT (the general threshold provided under the Mexican Corporate Income Tax Act is 183 days). The current CIT rate is 30% on taxable income. The company is required to fill out CIT forms and report its taxable income from Mexican sources.

It is anticipated that the CIT rate that Pemex currently bears will be reduced, making it more competitive and giving it the ability to devote more of its own profits to exploration and development activities. The Mexican government intends to fill any shortfall in its budget from increased oil and gas drilling revenue, based on the recently released draft of the Hydrocarbon Revenue Tax Act.

Delivery of production and economic payments

Service contracts

Under a service contract, the oil company will deliver the hydrocarbons production to the government of Mexico in exchange for cash payments to be provided in each contract. Payment to the contractor shall be made by the Petroleum Fund. No other fees or royalties will be included in service contracts.

Licenses

A foreign oil and gas company (exploration and production company) can obtain a license (similar to a lease of mineral rights) either directly through the auction process for non-Pemex controlled fields or through a joint venture with Pemex, which oil and gas field Pemex acquired under an "asignacion". The foreign company would have the right to the minerals once the minerals have been extracted from the ground. The foreign oil company would be required to make four types of economic payments to the Mexican government: (i) an upfront signing bonus; (ii) a monthly quota during exploration of $1,150 pesos (approximately US$100) per square kilometer which increases after 60 months to $2,750 pesos (approximately US$200) per square kilometer to incentivize the company to drill; (iii) a royalty payment on production once production begins; and, (iv) compensation to the government based on either operating profit, or the contractual value of the hydrocarbons produced. The amounts referred to in (i) and (ii) above will be annually updated in accordance with the Mexican Consumer Price Index.

The compensation to the government under clause (iv) above is determined by applying a percentage or rate to the operating profit or value of hydrocarbons determined by multiplying the price per barrel and the volume in barrels produced. The rate and the price will be determined in each contract according to its terms. The value of the hydrocarbons can be reduced by the royalties paid and the costs and expenses of exploration and production. Certain costs and expenses are non-deductible, such as financial costs, penalties, the cost of easements and rights of way, the quotas paid during the exploration phase, and certain advisory fees. These payments are in addition to the general CIT to be paid by the foreign oil company.

Profit sharing and production sharing contracts

With respect to profit and production sharing contracts, the foreign oil and gas company will have to pay: (i) a monthly quota during exploration which increases after 60 months as described above; (ii) royalties on production once production begins; and (iii) compensation determined as a percentage of operating profit. With respect to this last clause, the oil and gas company can recover its costs as a deduction from operating profit and can keep any operating profit in excess of the percentage paid to the Mexican government. In profit-sharing contracts, the oil and gas company will deliver all of the production to the marketing company hired by the CNH, which shall deliver the sale revenues to the Petroleum Fund.

Royalty rates

The royalty rates for petroleum are determined based on whether the price per barrel is below $48 or equal to or above $48. If below, the royalty rate is 7.5%. If $48 or above, the rate is equal to [(0.125 x price per barrel) + 1.5]%. So if the price of oil is $100, the rate is 14%.

.125 x 100 = 12.5 First calculation
12.5 + 1.5 = 14% Second calculation

For gas mixed in with oil coming out of an oil well, the royalty rate is the price of gas divided by 100. For gas coming from gas wells, there is a formula. First, if the price of gas is equal to or below $5, the rate is 0%. If the price of gas exceeds $5, but is less than $5.50, the rate is = [((price - 5) x 60.5) divided by the price]%. When the price exceeds $5.50, the rate is equal to the price divided by 100.

5.25 - 5 = .25 x 60.5 = 15.125 First calculation
15.125 divided by 5.25 = 2.881% Second calculation

Tax rules

The Ministry of Finance and Taxation is charged with administering the economic benefits paid to the government by the companies carrying out the exploration and production activity, as well as collecting corporate income tax from those companies. The two systems, economic payments and tax liabilities, are to a certain extent interdependent. The Hydrocarbon Revenue Tax Act provides special depreciation rates that an oil and gas company can use instead of the depreciation rates used for corporate income tax under the CIT. A foreign company that works under a license, profit sharing or production sharing contract will have a permanent establishment (taxable presence) if it remains in Mexico or the Mexican exclusive economic zone for a period exceeding 30 days in any 12 month period.

Companies which have won these types of contracts will not be able to file consolidated income tax returns with affiliated companies. They will be required to file separate returns. In addition, transfer pricing rules will apply to Mexican subsidiaries of foreign multinational groups.

Taxation of US companies

Treaty exemptions to the CIT

US companies sending employees to Mexico to collect and review seismic data and then to conduct exploration and development activities will need to address whether and when they become subject to the Mexican CIT in light of the 30 day rule.

Article 5, paragraph 2(f) of the U.S. - Mexico Tax Treaty provides that a:

"permanent establishment" includes an oil or gas well or any other place of extraction of natural resources. Paragraph 3 of Article 5 states: "The term 'permanent establishment' shall also include a building site or construction or installation project, or an installation or drilling rig or ship used for the exploration or exploitation of natural resources, or supervisory activity in connection therewith, but only if such a building site, construction or activity lasts more than six months."

If a service contract lasts longer than 30 days, but less than six months, the question is whether a U.S. service provider can claim an exemption from Mexican CIT. Article 5, paragraph 5, of the US - Mexico Tax Treaty provides that a US enterprise would have a permanent establishment in Mexico if it sent a dependent agent to Mexico where the agent had, and habitually exercised, authority to conclude contracts in the name of the US enterprise. So long as the employees of the US oil and gas service company that are performing preliminary work do not have the authority to conclude contracts that bind the US company, the US company should be entitled to claim under the US - Mexico Tax Treaty that such activities, even though lasting more than 30 days, do not create a taxable presence in Mexico. Care should be taken by any US employer on behalf of its employees performing services in Mexico to comply with Mexican labor and employment tax laws.

Reduced withholding rates under the treaty

Mexico recently enacted tax legislation that went into effect on January 1, 2014, that among other things, imposes a new 10% withholding tax on dividends paid by Mexican companies to non-residents. Under Article 10 of the US - Mexico Tax Treaty, that rate can be reduced to 5% if the US shareholder owns at least ten percent of the voting stock of the Mexican company paying the dividends. Mexican withholding tax can be eliminated on dividends paid by a Mexican subsidiary of a US corporation if the US corporation owns at least eighty percent or more of the voting stock and certain other specific requirements are met. In order to obtain benefits under the US - Mexico Tax Treaty, a US taxpayer will have to provide a certificate of tax residence (IRS Form 6166) to the payor. A US tax resident will need to file an IRS Form 8802 to request a tax residence certificate from the Internal Revenue Service. In certain cases, the US taxpayer may need to appoint a legal representative in Mexico and file certain information with the tax authorities.

US oil and gas companies that go to Mexico to participate in the energy reforms, including oil and gas exploration, power and infrastructure projects, must take into account the CIT, the Hydrocarbons Revenue Tax Act and the US - Mexico Tax Treaty to determine the CIT liability, if any. Furthermore, there remains the possibility that an investor could modify or reduce its CIT liability by agreement in one or more of the contracts described above with the approval of the Ministries of Energy and Taxation. Therefore, investors should monitor the implementing legislation which is being debated in the Mexican Congress. The final legislation could have a great impact on the after-tax return of any investment in the liberalized Mexican energy industry.

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**As this reform is under discussion by the Mexican Congress, the content of this article may change depending on the actual legislation enacted by the Congress.