14 September 2016 Mexico's proposed 2017 tax reform package includes provisions that may affect the oil and gas industry Mexico's President has submitted a tax reform package to Congress. The proposed tax reform includes a number of provisions that may be relevant to the oil and gas industry. On September 8, 2016, Mexico's President, Enrique Peña Nieto, presented the 2017 tax reform package (the Proposed Reform) to the Mexican Congress for approval. The Proposed Reform includes amendments to the Income Tax Law, Value Added Tax Law, Federal Fiscal Code, Hydrocarbons Revenue Law (HRL), and Federal Duties Law. The reform package must now be debated and approved by the two chambers of Congress. If passed and enacted, the reform will be effective as of January 1, 2017. The President also proposed the 2017 Federal Revenue Act, which would replace the 2016 Federal Revenue Act. This Tax Alert discusses the most significant items included in the Proposed Reform for the oil and gas industry. Under current legislation, the HRL establishes that contractors receive extracted hydrocarbons as in-kind consideration under license contracts (License) and a percentage of the produced hydrocarbons under production sharing contracts (PSCs). Although this in-kind consideration might be considered as taxable income, the Federal Government argues that only income obtained from the sale of hydrocarbons should be considered in the contractor's taxable base. Accordingly, the President proposed to establish in the Mexican Income Tax Law (MITL) that in-kind consideration obtained by a contractor in a License or PSC should not be considered as taxable income, to the extent that such consideration is not deducted as cost of goods sold when transferred or sold. Under current legislation, the HRL includes specific depreciation rates that E&P companies may use on investments made in hydrocarbon extraction and exploration activities. To provide clarity to the oil and gas industry, the Federal Government proposed amending the MITL to include a specific depreciation rate of 10% that would apply to: (1) fixed assets used for hydrocarbon transportation, storage and processing; (2) platforms, rigs and drill ships; and (3) processing and storage vessels, like floating production, storage and offloading (FPSO). The proposal does not specify depreciation rates applicable to assets used in the transportation and distribution of refined products, natural gas and petrochemicals, which might be important to include in the provision. The MITL establishes that taxpayers with annual income lower than MXN $13 million are not required to maintain documentation to comply with transfer pricing requirements (i.e., obtaining transfer pricing reports). Because of the large expected investment volumes in the E&P sector, however, the Federal Government proposed eliminating the documentation exception for E&P companies as they are already required by contract to produce those reports. Considering that the electric vehicle market in Mexico is just emerging and that almost a third of greenhouse gas emissions in Mexico come from fossil fuel burning, the Federal Government proposed a tax incentive to assist in reducing CO2 emissions and their environmental impact. The electric vehicle market has stalled in past years because there is no consumer demand and consumers have limited access to electric charging stations. To encourage gasoline providers to include power feeders in their stations and to accelerate the adoption of electric vehicles in Mexico, the Proposed Reform would provide a 30% credit on investments made in such assets creditable against income tax payable in the year the investment is made. The Proposed Reform would require the feeders to be physically fixed to publicly accessible service points. If the credit exceeds the taxpayer's payable income tax for the fiscal year, the Proposed Reform would allow the taxpayer to apply the credit balance against income tax for the following 10 fiscal years. To promote investment in technology R&D companies, the Federal Government is proposing a tax incentive that would provide a 30% credit on expenses and investments made in technology R&D activities. Taxpayers would claim the 30% credit against income tax payable in the year the investment is made or expense is incurred. Taxpayers would determine the amount to which the 30% credit applies by subtracting the three preceding years' average investment/expense on technology R&D activities from the current fiscal year investment in the same activities. That amount would be the creditable balance that taxpayers could use against their payable income tax. The Federal Government would issue regulations that would establish the activities, sectors and products to which the incentive would apply. It is anticipated that the credit would not apply against salary expenses for the development of these projects. The international decline of hydrocarbon prices has affected the deduction calculation for costs, expenses and investments in exploration and extraction activities because the calculation relies on the value of the extracted hydrocarbons. The deduction may be higher or lower depending on the hydrocarbon prices, which also affects the determination of the profit-sharing fee. To protect Petroleos Mexicanos (PEMEX) from economic exposure, the Ministry of Finance published, on April 18, 2016, a Decree that included a tax incentive for PEMEX regarding profit-sharing fees for exploration and extraction contracts. According to the Decree, PEMEX may choose to apply one of the following alternatives, for purposes of determining the deductibility limit for costs, expenses and investments in onshore or offshore areas with water depths lower than 500 meters if provisional payments are made: — Onshore: The higher amount between USD $8.30/BOE (barrel of oil equivalent) or the amount resulting from applying 12.5% to the annual value of the hydrocarbons that are not natural gas or condensates — Offshore: The higher amount between USD $6.10/BOE or the amount resulting from applying 12.5% to the annual value of the hydrocarbons that are not natural gas and condensates, under Section II of Article 41 or Section I(b) of Article 42 The Federal Government proposed including the Decree in the HRL and making it applicable not only to PEMEX but to all assignees. Currently, the HRL requires the adjustment mechanism included in contracts, established under the HRL, to be derived from a formula that depends on the contractor's profitability. The Proposed Reform states that measuring profitability imposes a significant burden. As a result, the Federal Government would eliminate the profitability element and broaden formula alternatives for the adjustment mechanism without losing its current progressive nature. Companies that have been awarded E&P contracts and have opted to operate under consortiums must enter into a joint operating agreement that establishes their participation percentages. Additionally, the HRL establishes that the operator shall issue the invoices to consortium members for the expenses incurred as a consequence of executing the contract. Each consortium member's deductible expense is the amount that corresponds to the percentage of participation set forth in the joint operating agreement. The Federal Government explained that this may cause distortions in the way members' funding responsibilities are recognized because costs are not always distributed proportionally to the participation (i.e., carry). For this reason, the Proposed would allow each of the consortium members to deduct the costs they have effectively incurred in, but not only in, proportion to their participation. The Proposed Reform would eliminate the ability of taxpayers to estimate the VAT triggered through preoperative expenses and investments and obtain reimbursement for that amount. Instead, the Proposed Reform would allow preoperative VAT to be creditable until the first month in which the taxpayer starts carrying out activities that are subject to VAT or to the 0% tax rate. The Proposed Reform includes a list of activities that would be considered as preoperative expenses or investments (i.e. R&D related to the design, manufacturing and improvement of a product), to the extent that such activities are carried out before the performance of activities subject to VAT. This proposal may significantly affect infrastructure projects, as developers may have to finance VAT during the whole construction period. Taxpayers should recalculate the VAT creditable against income tax based on inflation, but taxpayers would have to absorb the difference between inflation and the cost of capital. The Proposed Reform would, however, establish an exception for the hydrocarbons extraction industry that would allow taxpayers to credit the preoperative VAT triggered by extraction activities against income tax to the extent the extraction activities are not ceased or are ceased as a consequence of facts and circumstances that are not attributable to the taxpayer. If the extraction activities are ceased, the Proposed Reform would require companies to recognize the reimbursed VAT in the next month following the month in which such activities were ceased. The Proposed Reform would establish that the creditable VAT amount should be calculated under the simplified method included in the VAT law. Under the simplified method, when calculating the creditable VAT amount for the current fiscal year, taxpayers must take into consideration the proportion of activities taxed for VAT purposes in the preceding year. Alternatively, the Proposed Reform would establish that, for the first and second years of operation, taxpayers must take into account the preceding month's VAT determination when calculating the current month's creditable VAT amount. The Proposed Reform would clarify the VAT treatment applicable to assets that are being leased by non-Mexican residents and imported by the Mexican lessee. For VAT already paid upon the importation of the assets, the Proposed Reform would clarify that it is not necessary to pay VAT for the fees or rents paid for the use of such assets. The Proposed Reform would clarify that services rendered abroad are deemed as imported into Mexican territory when they are effectively paid. The Federal Government did not propose any modifications to this specific tax. It is expected, however, that gasoline and diesel prices will be liberalized (i.e., prices will no longer be set by the government) at the beginning of 2017, and the transitioning pace to open market conditions will be determined for each region by the Energy Regulatory Commission and the Federal Anti-Trust Commission. For your reference, below please find an excerpt from a chart included in the Proposed Reform, which includes a tax revenue comparison as a percentage of the GDP considering revenues that include the collection of IEPS from oil and gas companies and revenues that do not include the collection of IEPS from oil and gas companies. This could be intended to show Congress the effect on Federal revenues of oil and gas IEPS collection from oil and gas companies. Accordingly, the Proposed Reform would not reduce the IEPS imposed on oil and gas companies. The Proposed Reform would add new provisions to the FFC that would simplify the proper application of tax regulations, improve the voluntary compliance of tax obligations and strengthen tax authorities' auditing abilities. Accordingly, the Proposed Reform would broaden the use of the electronic signature by allowing taxpayers to use the electronic signature in private transactions, to the extent taxpayers comply with the electronic signature regulations. In addition, the Proposed Reform would broaden the use of the electronic inbox or "Buzón Tributario" -used only for tax compliance purposes- to allow taxpayers and, in general, individuals to interact with authorities from all sectors through this electronic platform. The Proposed Reform also would require a company's legal representatives to register with the Federal Taxpayer Registry. Additionally, electronic invoices would only be cancelled if the person to which the invoice is issued agrees to the cancelation. A prior tax reform modified PEMEX's legal nature from a decentralized organization to a State Productive Company. Despite that change, under the Federal Duties Law, PEMEX still receives special treatment as a decentralized organization. Therefore, the Federal Government proposed eliminating the following provisions to give PEMEX the same economic conditions as its competitors: — PEMEX and its subsidiaries' exemptions from customs duties for natural gas importations or exportations, as well as customs duties on the provision of fuel for leased foreign vessels used for its activities — Preferential rates on annual duty payments for the transportation and distribution of refined products through pipelines — Preferential rates on duties for the transfer, storage and distribution of refined products through pipelines The proposed 2017 Federal Revenue Act includes two new articles. One article would impose additional obligations for holders of marketing, distributing and retailing permits for certain petroleum products. The second article would increase the functions to be carried out by the Energy Commission with regard to the regulation of oil prices. In addition, below please find some relevant budget adjustments made to PEMEX in terms of authorized leverage for 2017 vs 2016. The amounts represent how much PEMEX would receive from domestic borrowings (i.e., internal leverage) and foreign institutions, banks and other organizations (i.e., external leverage).
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