In an attempt to encourage private investment in the energy and infrastructure sectors, and to offer a vehicle through which different investors are able to participate, the Mexican Government has created a new security to be quoted in the stock markets in the form of certificates to be issued by a Mexican infrastructure and energy trust or Fideicomiso de Inversion en Bienes Raíces for the energy sector (FIBRA-E). Alberto Alvarez of Chevez, Ruiz, Zamarippa y Cia breaks down the most innovative features of the new regime.
The FIBRA-E is intended to provide investors, sponsors and fund managers with a new legal and tax framework suitable for the kind of projects at which this is aimed, based on the legal platform in place for the Mexican Real Estate Investment Trusts or FIBRAs.
This new investment scheme seeks to share with the investors or certificate holders a turnover with respect to the cash flow generated by energy and infrastructure projects, granting tax transparency to them throughout the whole structure, so that the tax effects are recognised directly by them in terms of their specific tax regime, relieving Mexican pension funds, Mexican individuals and foreign residents from the capital gains Mexican income tax derived from the sale of the certificates in the stock markets.
On the other hand, it is intended that sponsors will be able to monetise their assets for any purposes they deem fit through the sale of their shares to the FIBRA-E in exchange for resources obtained from the investors derived from placing the certificates in the stock markets.
The Mexican tax authorities have recently published certain administrative rules containing the specific regulatory tax framework applicable to a FIBRA-E, to their certificate holders and to asset holders selling their projects. These rules entered into effect on October 1 2015.
Investment scheme goals
Unlike real estate FIBRAs, a FIBRA-E is required to invest in shares issued by Mexican special purpose companies (the promoted entities), and not in real estate. A FIBRA-E is not entitled to grant financing to the promoted entities.
The targets upon which a FIBRA-E has to focus are promoted entities that have as exclusive activity the performance of some oil & gas activities (not including upstream), energy sector entities, infrastructure projects and management of the FIBRAS-E's activities or a combination of them. A promoted entity may have different shareholders different from the FIBRA-E, however such shareholders should also be Mexican legal entities – even before the FIBRA-E becomes a shareholder.
Investing in shares rather than assets clearly seems to be a smart feature of this regime, since it will allow a FIBRA-E to be more efficient in the management and use of its financial resources, as it would not be necessary to incur financial costs derived from the VAT recovery procedure in such transactions.
However, even though from a legal perspective shares should be acquired by a FIBRA-E, the form through which the tax effects are determined from such transactions by sponsors selling shares and by the FIBRA-E itself, are more similar to those applicable when an asset deal takes place. This feature may lead to some problems, as described below.
In a measure which seeks to encourage investment in brownfield projects, a restriction for the promoted entities has been established: no more than 25% of the average book value of their assets shall be new, which is defined as having been acquired and operated less than 12 months before. This threshold has to be measured at the level of each promoted entity and not at the level of the FIBRA-E.
An additional measure to encourage FIBRAs-E to invest in mature projects is that, in the specific case of infrastructure projects, the contract or concession held by the promoted entity should be in operation, bearing in mind that the life of such contract or concession should be at least seven years or longer at the moment the FIBRA-E acquires the promoted entity's shares.
These restrictions may represent a challenge for FIBRAs-E managers, since they will have to balance the vehicles' pipelines between brown-field or mature projects versus new opportunities or green-field projects that could be viewed as an attractive investment because of their lower entry costs.
FIBRA-E entry mechanism
There is no restriction for a FIBRA-E to act as shareholder of a promoted entity jointly with other Mexican sponsors irrespective of the form through which the shares are acquired. However, the tax outcome of following the first or the second approach is different and may create controversy between the parties at the time entry of the FIBRA-E into the projects is negotiated.
As opposed to the acquisition regime in the real estate FIBRAs, the possibility to defer the income tax derived from the gain obtained in the transfer of shares into the FIBRA-E does not exist for sponsors under this regime, even if they receive certificates issued by the FIBRA-E in exchange for the shares transferred.
The income tax which arises will be paid by the sponsor through an alternative procedure that consists of determining a theoretical gain or loss as if assets and not shares were being sold, by subtracting from the sale price agreed between the parties, the tax cost basis of the land, fixed assets or deferred costs that are within the promoted entity, rather than using the tax cost basis of the shares that are being transferred.
Another element that makes these transactions similar to an asset acquisition is the fact that any debt owed by the promoted entity that is being assumed by the FIBRA-E as a new shareholder of such entity increases the sale price of such shares. This happens whenever an asset that is being purchased is granted as collateral in a loan by the vendor where the proceeds of the sale are used by such vendor to pay the loan in order for the asset to be released.
The fact that the there is no tax deferral for the sponsors, and that the acquisition mechanics are similar to those under an asset deal, may create a barrier to entry for them since, being mature projects, it is anticipated that their tax cost basis on the assets, which is diminished by the tax depreciation throughout their life, could be lower than their tax cost basis in the shares being transferred, causing them to pay income tax on a higher tax basis.
Meanwhile, the FIBRA-E that acquires such shares should recognise, in the determination of its annual tax result, a deferred deduction or income (in case there is a loss incurred by the project holder selling the shares) at an annual 15% rate on 'goodwill', which is equivalent to the gain or loss that the sponsor transferring the shares into the FIBRA-E has obtained in terms of the previous paragraph.
The fact that one party is able to claim an annual tax deduction on goodwill equivalent to the taxable gain obtained by the other party is an element that parties may disagree on.
This situation may arise when challenging M&A processes where each party would try to negotiate using the tax impact on the transaction as its main driver. This may lead the negotiations in the direction of:
- Complex corporate reorganisations performed by project holders to try to diminish their taxable gain, so that a portion of the tax benefit is transferred to the investors;or
- Increased sale prices that allow sponsors to pay their corresponding taxes without suffering any impact on the expected cash flow from the transaction, sharing the tax benefit of the goodwill deduction with investors.
It is also worth mentioning that new reorganisation rules are being included to allow sponsors to reorganise their projects to allocate them into a Mexican legal entity, which will be able to transfer the shares issued by the new promoted company into the interested FIBRAs-E.
New tax features
A breakthrough feature in this scheme is that, for the first time within all the Mexican tax legislation, the promoted entities which FIBRAs-E invest in could be considered as transparent entities for income tax purposes. This means that shareholders, including the FIBRA-E itself, shall recognise their tax effects directly, without being subject to additional taxes at the level of the promoted entity.
Promoted entities would have to determine a tax result considering any income derived from the activities performed, minus the corresponding deductions incurred, including the depreciation of fixed assets and deferred expenses at the value they had been considering before the FIBRA-E becomes a shareholder.
At least 95% of such a tax result would be distributed, annually, to shareholders, who would have to treat it as taxable income (in case of the sponsors) or include it in their own tax result, which should also be distributed on an annual basis for the benefit of the certificate holders in case of the FIBRA-Es. Distributions made by the promoted entities to FIBRA-Es are not subject to the 10% withholding tax applicable on dividends.
The tax transparency of both the promoted entities and the FIBRA-E allows the certificate holders to access the deductions claimed at both levels, including the depreciation of fixed assets and deferred expenses at the level of the promoted entities, as well as the goodwill depreciation at the level of the FIBRA-E.
This tax feature could cause investors not to be subject to taxation on the proceeds distributed to them by the FIBRA-E until a taxable result of the FIBRA-E is determined (which can happen once the goodwill deduction is exhausted), making the investment scheme more appealing than other options available in the market.
Distributions made by the FIBRA-E to its certificate holders out of the tax result would be subject to a withholding tax of 30%. Each certificate holder would have to consider such amount as taxable income being able to credit the tax withheld.
There is no withholding tax on distributions made to Mexican pension funds (either public or private), however, foreign pension funds will be subject to this withholding tax as opposed to their tax exempt treatment granted under the real estate FIBRA regime. This may prevent these funds from using this investment mechanism.
Solid and efficient tax framework
In general terms, FIBRA-E rules provide a solid and efficient tax framework for all participants in the scheme due to features such as the tax transparency of their whole structure, the exemption on the sale of certificates in some cases, the non-existence of a withholding tax at the level of the promoted entities, along with the fact that profits that may be distributed are not subject to the 10% income tax applicable on dividends.
However, to achieve a more appealing tax framework and to avoid some of the negative issues described above, it would be advisable to allow the sponsors to defer the income tax on the sale or at least give them the possibility to use the tax cost basis of the shares that are being transferred, instead of the assets' cost basis.
It should also be considered that adding the amount of debt owed by the promoted entities to the sale price of the shares would have a significant tax impact for the sponsors, irrespective of the tax cost basis used, due to the level of financing that sometimes is required for energy and infrastructure projects.
Finally, to provide legal security and certainty to all participants, it is desirable that the regulatory tax framework is incorporated into the Mexican Income Tax Law and not into administrative rules, which can be subject to further modification by the tax authorities without any legislative process as there are new concepts in such rules upon which investors, sponsors and fund managers would have to rely to launch this kind of vehicle.
The author wishes to thank Iván Moguel for his comments on this article. He would also like to thank Isabel Rodríguez and Bernardo Iberri for their assistance in the drafting of this article.
Previously published by International Tax Review
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.