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Mexico’s Tax Regime: Scaring Off Oil Company Investors?

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Mexico’s historic energy reform has understandably whetted the appetites of oil companies worldwide. But, concerns are growing that Mexico’s tax terms might turn out a little too tough – potentially scaring off, rather than attracting, investors.

How so? Let’s recap: Mexico expects to offer a range of licences and profit – or production – sharing contracts to private investors in a tender next year, the terms of which may become known in late in 2014.

Full details of the tax terms will depend on the licences or contracts on offer, but the government has given some broad outlines, including that the total tax take could be as high as 75 per cent.

That looks around the international ballpark, so what’s the problem?

Potentially two things, at least for foreign majors, who have vented their concerns in private forums, to the government and to their lawyers.

One is the concept of so-called “ring-fencing”, which the World Bank sums up as:

A limitation on consolidation of income and deductions for tax purposes across different activities, or different projects, undertaken by the same taxpayer

The other is a time-limit on the ability to amortise losses. Companies would have 10 years to deduct such losses from investments, despite the fact that in some projects – think deep- or ultra-deep water exploration, which can easily take more than a decade to bear fruit – they may not be making a profit in 10 years and would thereafter lose the ability to deduct the investment.

Here is Comexi, a think-tank, in a new report:

The combination of ring-fencing with the limit on amortisation of fiscal losses could produce an effective taxation rate higher in this sector than in other industries.

It fears there could be “distortions that inhibit investment” – a grave prospect: Inhibiting investment would defeat the whole point of the reform.

It’s a serious concern. As Eduardo Barrón, international tax partner at Deloitte in Mexcio told beyondbrics, the rules “could substantially increase” the effective tax rate for companies not in profit after a decade – though he noted that companies would take that into account when submitting offers during the tender process.

As is normal in the industry, oil and gas players in Mexico can expect to have to pay a royalty and other charges, besides Mexico’s 30 per cent corporate tax rate.

Jorge Luis Preciado, head of the main opposition PAN party in the Senate (the PAN, remember, pushed the government to make the reform much broader and more investment-friendly than originally planned), did a quick back-of-the-envelope calculation recently, telling foreign correspondents:

The most conservative estimates are that for every barrel that costs $100, $50 is oil revenue [for the state], $18 in value-added-tax, $6 in income tax and a specific tax that the finance ministry is going to impose, so more or less the government is taking away $82 with $18 for the company who extracts it.

Mind you, as Roberto Mendoza, senior corporate tax manager at KPMG noted, the legislation does offer the sector an exemption from a normally mandatory 10-per cent profit sharing scheme known as PTU, a potentially welcome sweetener.

Indeed, the government has to tread a fine line between being attractive enough to companies and keeping the lion’s share of revenue that comes from a non-renewable resource that belongs to the state.

But Miguel Messmacher, income undersecretary, told beyondbrics, neither ring-fencing nor the deductions limit should scare away petrodollars.

Ring-fencing is something used in other countries to ensure that the state receives the oil rent – it’s not something we’re inventing for Mexico or something that has impeded private participation in the sector in other countries. What we’re trying to avoid is that contractors can take costs from other activities and try to reduce what they have to pay in tax linked to hydrocarbons …

The 10-year limit on deductions is not something that applies especially to the hydrocarbons sector but is a disposition of income tax applicable to all productive sectors in Mexico, including some that have projects which take a long time to mature (steel plants, dams, roads, airports, etc). We have never had problems in those sectors.

On the contrary, it can be a blessing, he believes:

In fact, the time limit has served as an incentive for investment projects to be conducted more rapidly because a company is seeking income as fast as possible to be able to take advantage of this cost deductibility.

Pedro van Meurs, who has advised some 90 governments on oil and gas fiscal terms in the last 40 years, including consulting for Mexico’s state oil company, Pemex, on service contracts, and working in China, Canada, Bolivia and Kuwait, is not so sure.

In a new study of the legislation, he says:

The proposed Hydrocarbon Revenue Law significantly reduces the benefits that Mexico could obtain from the Constitutional change, despite attractive features in terms of fiscal structure, royalty rates and tax depreciation rates included in the proposed law.

He is concerned that the regime is too complex and bureaucratic; leaves too much to be decided in the contracts “creating significant possibilities for conflicts and a chaotic administration”; leaves “significant loopholes for contractors to achieve unwarranted profits”; creates loopholes for contractors to make “unwarranted profits”; and:

Introduces an excessive system of ring-fencing and establishes disincentives which will reduce investor interest for no particular benefit to Mexico

Ouch.

Of course, tax is just one of several elements investors will have to weigh in assessing whether to rush to Mexico or not. Compared with many other countries where oil and gas is extracted, Mexico looks like paradise – a stable economy, scant prospect of a sudden shift in the legal framework, plus proximity to the US with all the synergies and logistical benefits that brings.

It remains to be seen whether Congress – where approval of the energy bills to implement the reform have become bogged down in political horse-trading – will make any changes.

Mexico has done its homework carefully and the government knows it cannot afford for its first tender to be a flop. Special pleading by rich oil majors, then, or a real potential impediment to investment?

[readon1 url="http://blogs.ft.com/beyond-brics/2014/06/25/mexicos-tax-regime-scaring-off-oil-company-investors/"]Source:blogs.ft.com[/readon1]

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