Mexico: Energy Reform - Chapter IV: Implications On Income Tax Of Exploration And Extraction Activities Of Hydrocarbons

Last Updated: 30 June 2015
Article by Turanzas, Bravo & Ambrosi

1. Accruable income for Contractors under Contracts for Exploration and Extraction of Hydrocarbons

Pursuant to the provisions set forth in Article 31, paragraph II of the LISH, Contractors must have as their sole corporate purpose the Exploration and Extraction of Hydrocarbons; this matter is extremely relevant to determine the origin of accruable income that such entities are enabled to receive.

As a result of this restriction in their corporate purpose, Contractors may not carry on with any kind of activity other than Exploration and Extraction of Hydrocarbons, which from the Income Tax perspective implies that such entities will only receive accruable income from these activities, and cannot receive any other kind of income for any other activities.

Accruable income from the Exploration and Extraction of Hydrocarbons are the considerations received according to the nature of each of the Contracts in which Contractors take part; it is therefore essential to analyze the several considerations set forth in each one of those Contracts for this purpose, since these considerations will constitute accruable income when they represent a positive change in the Contractor's assets and estate.

That in the understanding that pursuant to the provisions set forth in Article 29 of the LISH, the consideration that Contractor is entitled to receive for its participation in the Contracts for Exploration and Extraction of Hydrocarbons, shall be paid once the Contractual Production is obtained; understanding as such these Hydrocarbons extracted in the Contractual Area, measured pursuant to the provisions issued by the CNH in the Point of Measurement, for the corresponding Period. Until there is such Contractual Production, Contractor is not entitled to receive any consideration or advance payment whatsoever.

While the Contractors' corporate purpose is limited to Exploration and Extraction of Hydrocarbons, the above does not imply such Contractors are prevented from carrying out any other activities that are required for the adequate compliance of such corporate purpose; therefore, such entities may well acquire real estate properties, obtain credits, subscribe credit instruments and, in general, carry on with any activity geared to the full execution of its corporate purpose.

The above opens the possibility to accidental or extraordinary acts that cause accruable income, such as the sale of those real estate properties; in which case, the Contractor must accrue such accidental or extraordinary income to those coming from the Exploration and Extraction of Hydrocarbons and, consequently, determine the corresponding Income Tax pursuant to the general rules set forth in the LISR.

1.1. Consideration from License Contracts

Consideration in favor of the Contractor under License Contracts is the transfer of Hydrocarbons once they have been extracted from the subsoil for money. For such consideration to be paid, the Contractor must be current in payment of the considerations set forth in favor of the State (non-tax-based income).

The price fixed for the transfer of Hydrocarbons in favor of Contractor for money must be attractive for Contractor, because after receiving those Hydrocarbons, this shall resell them for profit, and such resale contains the essence or economic benefit under the License Contract.

There are two positions regarding whether the Consideration under License Contracts is or not an accruable income in favor of Contractor.

  1. Not an accruable income.- The first view gears in the sense that the transfer of Hydrocarbons for money does not constitute accruable income for Contractor, inasmuch this has paid an economic consideration for the transfer of property of Hydrocarbons, but this does not cause a positive amendment to its assets or estate; that in the understanding that Contractor shall cause the respective Income Tax until it actually receives a profit for the resale in the domestic or international market of Hydrocarbons acquired under the License Contract.
  2. Accruable income.- The second view gears in the sense that the transfer of Hydrocarbons for money does constitute an income in credit for Contractor, in the proportion that the price fixed for such transfer is below the Hydrocarbon's market value. The above in other words, the economic benefit (difference between the preferential price and market value) that the Contractor receives for the transfer of Hydrocarbons for money that is made in its favor under the License Contract represents a positive change in its assets or estate, by creating an income in credit.

1.2. Consideration from Contracts of Shared Profit and Contracts of Shared Production

In the Contracts of Shared Profit and Contracts of Shared Production there are two considerations in favor of Contractors. The first of them is a specific consideration; while the second is the recovery of costs incurred in by Contractor.

- Specific considerations.

In the Contracts of Shared Profits, Contractors shall deliver all of the Contractual Production to the Trader (Comercializador), which shall deliver income from the trade of Hydrocarbons to the Mexican Oil Fund for Stabilization and Development.

The Mexican Oil Fund for Stabilization and Development shall retain considerations corresponding to the State (non-tax-based income) and pay to Contractor its respective consideration pursuant to the terms set forth in the Contract of Shared Profit. These considerations shall be the remainder of the Operating Profit after paying the Specific considerations in favor of the State (non-tax-based income).

The consideration delivered to the Contractor by the Mexican Oil Fund for Stabilization and Development shall have the legal nature of an income in cash that will have to be accrued by the Contractor in order to determine the corresponding Income Tax.

In the Contracts of Shared Production, on the other hand, the consideration in favor of the Contractor shall be paid in kind, with a ratio of the Contractual Production de Hydrocarbons that is equal to the value of the consideration set forth. This consideration shall be the remainder of the Operating Profit after paying the Specific considerations in favor of the State (non-tax-based income).

The consideration in kind delivered to Contractor shall have the legal nature of income in assets, which would have to be accrued by Contractor in order to determine the corresponding Income Tax, but the LISH fails to establish the parameters to accrue such income in assets.

There are several parameters to determine the amount for income in assets; the most relevant ones are appraisal value, market value and value set forth in a contract. We consider that the ideal method to determine the amount for income in assets under this Contract must be the value set forth in the contract, since payment in kind that shall be made to Contractor shall be determined based on the value of Hydrocarbons set forth in the contract.

- Cost recovery.

Recovery of costs is the second kind of consideration in favor of Contractors under the Contracts of Shared Profit and the Contracts of Shared Production. Said consideration shall be the amount equal to recognized costs, expenses and investments pursuant to guidelines issued for such purpose by the SHCP.

Said consideration, in each term, may not be above the Limit for Recovery of Costs, understanding as such the result of multiplying the Cost Recovery Ration by the Contractual Value of Hydrocarbons. The product of such multiplication shall determine the maximum ration of the Contractual Value of Hydrocarbons that may be allocated to cost recovery in each Period.

Recognized costs, expenses and investments that exceed the Limit for Recovery of Costs and that, therefore, are not paid to Contractor as considerations, shall be included in the consideration for subsequent periods.

Article 19 of the LISH provides that the following concepts may not constitute part of the consideration for cost recovery:

  1. Financial costs.
  2. Costs incurred in due to negligence or fraud of Contractor, or any person acting on its behalf.
  3. Donations.
  4. Costs and expenses related to rights-of-way, rights-of-pass, temporary or permanent occupations, leases or the acquisition of land, indemnifications and any other analogous figure.
  5. Costs incurred in consulting services, except those set forth in the guidelines issued by the SHCP.
  6. Expenses in connection with the infringement of applicable provisions, including risk management.
  7. Expenses regarding training or training program that do not comply with the guidelines issued by the SHCP.
  8. Expenses arising from the infringement of any conditions for security, as well as those resulting from the acquisition of assets that do not have manufacturer's guarantee or its representative against any manufacturing defects, in accordance with practices generally used by the oil industry.
  9. Expenses, costs and investments for use of own technologies, except those that have a transfer price study pursuant to the applicable legal provisions.
  10. Amounts recorded as provisions and fund reserves, except those for the abandonment of facilities as set forth in guidelines issued by the SHCP.
  11. Legal costs for any arbitration or dispute involving the Contractor.
  12. Commissions paid to agents.
  13. Payments for Royalties and Contractual Fees for the Exploration Phase under the Contract, as well as payment of the corresponding Considerations, expenses, costs and investments under other Contracts.
  14. Costs, expenses and investments above benchmarks or reasonable market prices, pursuant to the rules and basis for registration of costs, expenses and investments under the Contract.
  15. Those that are not strictly essential to execute the purpose of the Contract, those that are set forth in each Contract considering its circumstances or specific circumstances set forth in the guidelines issued for such purpose by the SHCP.

We consider that this consideration, due to the fact that it is cost recovery, must not be considered as an accruable income in favor of Contractor, because far from changing its assets and estate, it seeks to create a neutral effect thereon, by the recovery of costs.

Notwithstanding the above, there can be a double benefit in favor of Contractors, in case these deduct such costs for Income Tax purposes, because they are disbursements strictly indispensable to carry on with its Exploration and Extraction activities of Hydrocarbons and, additionally, they recover (without accruing) these expenses as contractual consideration. According to this view, it could then be argued that recovery of costs must be accrued by Contractor in order to create a neutral effect; however, due to the fact that the LISR does not establish the same catalog of non-deductible costs as Article 19 of the LISH establishes as non-recoverable, there would be a sensible distortion that would damage Contractors.

1.3. Consideration from Service Contracts

Pursuant to the provisions set forth in Article 21 of the LISH, considerations in favor of Contractor under Service Contracts shall be in cash and be set forth in each Contract, considering the industry's standards or uses.

The Mexican Oil Fund for Stabilization and Development shall pay such consideration to Contractor with funds from the trade of the Contractual Production arising from the respective Service Contract.

The consideration delivered to Contractor by the Mexican Oil Fund for Stabilization and Development shall have the legal nature of an income in cash, which will have to be accrued by Contractor in order to determine the corresponding Income Tax.

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