Mexican energy reform four years on

On July 12 2017 a joint venture (consortium) formed by three participants, a Mexican, an American and a British company, announced its first discovery of oil reserves made in the Mexican territory.

The finding was made in the Zama-1 well, which is a shallow field situated at a depth of 166 meters and approximately 60 km away from the port of Dos Bocas in the State of Tabasco. The finding was made nearly two years after the consortium was awarded the license to explore Block 2 (located in Veracruz) and Block 7 (where the Zama-1 well is located) during the first round of public biddings that was held in July 2015. Both the blocks are located in the shallow water Sureste Basin in the Gulf of Mexico, the most productive hydrocarbon region in the Mexican territory.

According to the terms that were agreed, the Mexican government will receive a 68.99% profit share from every barrel produced in the block. This amount could increase after considering taxes and fees.

Earlier this year, on March, an Italian company announced that after having drilled the Amoca-2 well it was able to affirm that the well had proven reserves of oil. The Amoca-2 well is located in a shallow field (it lies at a depth of 25 metres) and is located approximately 200km west of Ciudad del Carmen in the Bay of Campeche.

Later on, in mid-July, the same Italian company announced that the Amoca-3 well has proven to have multiple oil reserves. The Amoca-3 well is also located in a shallow field and is situated approximately 3km from the Amoca-3 well.

The Amoca-2 and Amoca-3 wells are in Block 1, which was awarded to the referred Italian company in the second round of public biddings held by the Mexican government back in 2015. The Mexican government will receive a 83.75% profit share from every barrel produced in this block.

The aforementioned announcements were made following the first drillings to be carried out by organisations other than the state-owned company Petróleos Mexicanos (PEMEX) since President Lázaro Cardenas expropriated all oil resources and facilities from foreign investors in 1938, nearly 80 years ago. Also, such findings derived from the first exploratory drilling processes that were made since Mexico allowed private investors to participate in its oil and gas industry as a consequence of the long-awaited energy reform that was passed in December 2013.

The discoveries that were made in the Zama-1, Amoca-2 and Amoca-3 wells seem to indicate that the first offshore exploration processes made by private companies since the Mexican government allowed foreign investors to participate in the energy sector have turned out to be successful.

In late 2013, the Mexican government, under the current administration, materialised a series of long awaited and much needed legal reforms that had, among other purposes, to encourage the country's exploitation of hydrocarbons and ultimately bring to an end the monopoly for the exploration and exploitation of hydrocarbons that had been held by PEMEX.

The reform that was passed in December 2013 aimed to attract private domestic and foreign investment into the energy sector for the first time since 1938, in order to eventually lower electricity and fuel prices. Another purpose of the reform was to modify the tax regime applicable to PEMEX and transform it into a state productive company, to be operated in the same manner as a privately owned company seeking at every moment to maximise its profits.

In a first stage, such modifications entailed material amendments to the Mexican constitution. Such modifications led the Mexican government to allow private investors to participate in the hydrocarbons and electric industries. These initial amendments were followed by a set of secondary laws that entered into force in August 2014.

Indeed, as part of the first set of amendments, articles 25, 27 and 28 of the country's constitution were amended in order to allow private investors to participate under contracts or permits in most areas of the oil, gas and electricity sectors. However the Mexican state continued to be the legal owner of resources located beneath the soil's surface.

Later on, the president sent Congress a bill proposing the enactment of nine laws and the reform of 12 previously existing laws which altogether constituted the secondary legislation. The secondary laws were finally published in the Official Daily and came into force on August 11 2014. Such secondary legislation aimed to update the applicable legal framework of the hydrocarbons and electricity sectors, specify the functions to be performed by different government agencies, and regulate environmental and social issues commonly faced by such sectors.

As a consequence of the legal framework that was laid out through the amendments to previously existing legislation and the enactment of new legislation, private Mexican and foreign persons were allowed to participate in the exploration and extraction of hydrocarbons under four types of contracts.

The options of contracts that became available were: i) service contracts (which already existed); ii) shared production contracts; iii) shared profit contracts; and iv) license contracts. The possibility to utilise a combination of the aforementioned four options was also allowed.

Service contracts are agreements whereby a private company sells the hydrocarbons that it extracts to the Mexican government at a price stipulated in the corresponding contract.

Shared production contract agreements allow the contractor to keep in-kind production that covers costs and their share of operating profit and then to deliver the remaining production to a trader appointed by the Comisión Nacional de Hidrocarburos (the CNH).

In shared profit contracts contractors will deliver the entire contractual production to the trader and the latter, in turn, will deliver income derived from the commercialisation of the production to the Mexican Oil Fund, which will assume responsibility to pay the contractor, the consideration that may apply in accordance with the contract.

Finally, license contracts would be granted through a bidding process to be conducted by the CNH, allowing the contractor to have a right to the minerals it extracted after paying a variety of fees to the Mexican government.

The first public bidding processes to exploit the available fields or blocks commenced in 2015, and the granting of such licenses was designed to be carried out throughout five rounds to be held between 2015 and 2019, in which private investors are allowed to bid for the right to exploit fields that prior to the reform only PEMEX was allowed to exploit.

Through the first of such rounds (round zero) PEMEX was awarded the right to exploit specific areas in an exclusive manner. After the initial round PEMEX was able to retain areas in which it already operated, and it was awarded 83% of proven and probable reserves of the first round. The subsequent rounds were open to private companies and for partnerships with PEMEX.

Round one commenced in December 2014 and the first phase of round two began last June. These initial rounds encompassed shallow water, terrestrial and deep water reserves, and onshore blocks. The next auctions, in deep water and for shale blocks, are expected to be held at the end of this year or at the beginning of 2018.

As mentioned above, a set of secondary laws were enacted, in which it was proposed that PEMEX would be regarded as a taxpayer and, at the same time, lower its fiscal burden. In such secondary laws the authorities enacted the Hydrocarbons Revenue Law and the Regulations to the Hydrocarbons Revenue Law, the principal purpose of which was to lay out a regime in which the Mexican state will receive income derived from the activities of exploration and extraction of hydrocarbons carried out through the assignments and contracts to exploit the available fields. Furthermore, it was established the contractors should also comply with the Mexican income tax provisions.

The Hydrocarbons Revenue Law includes a ring fencing mechanism establishing that the bidding terms for the contracts and the contract itself may only be formalised with state productive companies or legal entities that comply with some requirements such as: i) they should be Mexican residents for tax purposes; ii) their purpose should consist exclusively of the exploration and extraction of hydrocarbons; and iii) they should not pay taxes under the optional integration regime for groups of companies.

Derived from the hydrocarbons exploration and extraction activities, the Mexican state could be able to receive income from different government fees, rights and/or compensations, as well as from income tax derived from the activities carried out by the contractors.

In this regard, the companies should recognise their income in accordance with the provisions established in the Mexican Income Tax Law and in the amount established in their contract, and should pay, according to their contract, certain amounts, which should be deductible for income tax purposes.

On matters related to the depreciation of investments for income tax purposes, the depreciation procedure based on the straight line method is maintained. However, in the Hydrocarbons Revenues Law specific deduction percentages may be applied instead of applying the percentages set forth in the Mexican Income Tax Law on: investments made for the exploration, investments made for the development and exploitation of oil fields and natural gas applicable to upstream activities, and investments made in some midstream infrastructure related activities.

Considering that in deep water projects for the exploration and extraction of hydrocarbons production usually begins after several years, taxpayers engaged in the aforementioned activities may offset tax losses incurred in a tax year, against profits, if any, realised in the following 15 tax years, instead of the 10 tax-year term set forth in the Mexican Income Tax Law.

Additionally, it is noteworthy that according to the provisions contained in the Mexican Income Tax Law that were already in force prior to the enactment of the energy reform, the thin-capitalisation restriction provided for Mexican resident legal entities with respect to interest derived from loans granted to them by foreign resident related parties, does not result in being applicable with respect to debt acquired in connection with upstream activities related to oil and other hydrocarbons.

Foreign residents engaged in the activities referred to in the Law of Hydrocarbons in Mexico would be considered to have a permanent establishment when such activities are carried out for more than 30 days in any 12-month period. For this purpose, activities carried out by related parties in respect of the same project are included.

The reform allowed for the possibility of participating in contracts of this sector by means of the concept of a consortium. This concept consists of two or more productive companies of the state and/or ordinary legal entities jointly filing a proposal within the bidding process for the awarding of the contract, with no need for incorporating a specific purpose entity for such purpose.

The concept of consortium does not have any legal capacity for purposes of tax law, other than that of the associates thereof, thus endowing this legal concept with complete tax transparency.

In terms of VAT, the Hydrocarbons Revenues Law establishes that the compensations will be taxed at a zero rate. Consequently, the contractors should recover the VAT transferred to them on the expenses and investments carried out, in order to execute the projects.

Despite the slump in oil prices in the past two years, as it was demonstrated through the findings that have recently been made in shallow water fields, the development of Mexico's offshore oil and gas resources has increased. Such a positive result has certainly been constructed based on the legal framework that was laid as a consequence of the 2013 and 2014 energy reforms.

It can be expected that the already available legal framework along with a gradual market recovery, will continue to allow achieving the goals of the country's energy reform, as the new rules have certainly allowed clarity as to the obligations and conditions that all participants in the industry are subject to.

Samy Lazarov

Chevez, Ruiz, Zamarripa y Cía Vasco de Quiroga 2121 4º Piso, Peña Blanca Santa Fe CP 01210 México Tel: +52 (55) 5261-5670 slazarov@chevez.com.mx www.chevez.com Samy Lazarov joined Chevez, Ruiz, Zamarripa y Cía in 2002 and became a partner in 2015. His areas of expertise include the development of tax strategies and restructuring for Mexican and non-Mexican corporations, including M&A transactions, oil and gas, energy and infrastructure projects, participation in IPOs and other investment instruments. He is involved in cross-border planning as well as on tax wealth planning for high net worth individuals. He is a public accountant who graduated from the Universidad Iberoamericana. Currently, he is a member of the College of Public Accountants of Mexico and of the Mexican Institute of Public Accountants. He is also member of the Mexican Branch of the International Fiscal Association (IFA) and of the Society of Trust and Estate Practitioners (STEP). He has published several articles in national as well as international publications on taxation.

Bernardo Iberri

Chevez, Ruiz, Zamarripa y Cía Vasco de Quiroga 2121 4º Piso, Peña Blanca Santa Fe CP 01210 México Tel: +52 (55) 5257-7098 biberri@chevez.com.mx www.chevez.com Bernardo Iberri is an associate at Chevez, Ruiz, Zamarripa y Cía in Mexico City. He is specialised in federal taxation matters in Mexico, with an emphasis on cross-border transactions and investment structures. Bernardo is a public accountant from the Instituto Tecnológico Autónomo de Mexico (ITAM) in Mexico City, where he took a postgraduate course in corporate advisory. He holds a master's degree in international taxation from the University of Sydney and took a postgraduate course in energy law in Escuela Libre de Derecho in Mexico City.