Electricity auctions in Mexico – relevant tax considerations for investors
When evaluating energy projects in Mexico it is common for companies focused on commercial and business matters to persevere without analysing the tax and legal considerations. These pose risks to the project, company and its shareholders' internal rates of return.
One of the most relevant processes going on in Mexico due to the opening of the energy sector is medium and long-term electricity auctions organised by the National Centre for Energy Control (CENACE, as per its Spanish acronym). The auctions are attracting a lot of foreign interest.
The main purpose of the medium-term auctions is that buyers acquire in advance power and electricity, reducing exposure to risks in the short-term price market. The main purpose of the long-term auctions is to allow suppliers to enter into long-term competitive agreements to provide clean energy, capacity, and clean energy certificates.
As of now, two long-term auctions have taken place in Mexico, and the third one is currently taking place. The third long-term auction contracts will be awarded on November 22 2017. This auction has gained significant attention from different investors including companies engaged in this sector and private equity funds. The main difference between this long-term auction and the previous ones is that the Federal Electricity Commission (CFE, as per its acronym in Spanish) would not be the only buyer, but other purchasers were able to participate.
As this is a new sector for private companies in Mexico, many participants in the auctions are foreign companies. In fact, the auction guidelines for the long-term auctions provide that foreign companies can participate in the bids. However, if a contract is awarded, it has to be executed by a Mexican special purpose vehicle (SPV) over which the foreign entity has to have control.
From a tax and legal perspective, it is important that foreign companies set up a proper corporate structure to make these types of investments in Mexico. In many cases, it is common that companies investing in this sector focus only on business and commercial matters without analysing the potential tax and legal consequences carefully. Regardless the fact companies were already awarded with agreements or made investments in the past, they should verify if their current corporate structure is the most accurate based on their business plans or if a restructure might be necessary.
From a Mexican tax perspective, it is important that foreign companies set up the proper structure for purposes of:
Repatriation of capitals, as Mexico has a lot of withholding taxes;
Avoiding trapped cash issues, as diverse accounting, and tax rules apply for distributions out of Mexican companies;
Avoiding tax risks, such as the constitution of permanent establishments in Mexico;
Complying with double tax treaties entered into by Mexico to apply reduced withholding tax rates (if applicable); and
Creating financial efficiencies improving the project’s and shareholder’s internal rate of return.
From a legal perspective, it is essential that foreign companies set up the proper structure to comply with the auction rules and other requirements such as corporate policies, financing conditions, guarantees, among others.
In addition to the structure, companies in Mexico in the electricity sector should have in mind that there are particular tax provisions and considerations applicable that may have a relevant impact on the projects’ and shareholders’ internal rates of returns.
Below is a summary of some of these key tax aspects:
In Mexico, tax rules do not follow the accounting rules, specifically in this sector. Companies should identify these differences.
Machinery and equipment for clean energy generation may be depreciated at a 100% depreciation rate for corporate income tax (CIT) purposes. Companies should have a detailed breakdown of the assets and expenses.
As most of these projects require significant investments and expenses at the beginning, more likely Mexican companies would generate tax losses that may be carried-forward for only 10 years. Companies should evaluate if they would be able to carry-forward losses within this period.
In line with the previous point, as most of these projects require significant investments and expenses at the beginning, more likely favourable VAT balances would be triggered. In 2017, rules for VAT refunds in preoperative periods were enacted. Companies should analyse these provisions in detail and make sure refund requests are filed properly.
Tax losses affect the tax-cost basis of the shares. It may have an impact on exit strategies as the income tax may be paid on the net gain in case of a sale of shares. In the event of an exit, companies should analyse applicable alternatives.
As mentioned, specific rules for distributions apply in Mexico. Companies have to recognise an after-tax net profits account balance (CUFIN, as per its Spanish acronym), which is a tax account where profits that already paid taxes should be registered. Companies can distribute dividends only if they have retained earnings for accounting purposes. If they have retained earnings for accounting purposes but do not have a CUFIN balance, income tax would be triggered at the point of distribution. Derived from the difference between accounting and tax rules this is very common. Nonetheless, a specific tax attribute for clean energy companies is applicable, called the ‘CUFIN E’. In very broad terms, the CUFIN E is an account for tax purposes in which tax profits should be registered. However, instead of computing the tax profits applying the available 100% depreciation rate for machinery and equipment for clean energy, a 5% should be applied. As a result, tax and accounting profits should be more similar. To the extent dividends are distributed from the CUFIN E, companies should not pay additional income tax (except for dividend withholding taxes, if applicable). Companies should evaluate if this provision creates efficiencies for the shareholders.
Thin capitalisation rules are not applicable for clean energy projects. Thus the debt-to-equity ratio may be higher than three-to-one and interest for loans with foreign-based related parties should still be deductible to the extent other requirements are met. Companies should evaluate their financing structure and their debt to equity ratios.
It is common that Mexican companies engaged in this sector require specific services and make certain payments such as development and success fees. As specific provisions to deduct expenses in Mexico apply, companies should be carefully analysed.
Due to the nature of the activities needed for these projects, foreign companies involved should analyse in detail the activities performed, to assess if there is a permanent establishment risk in Mexico.
Santiago Llano Zapatero (Sllano@ritch.com.mx)
Diego A. Hernandez Barrios (Dhernandez@ritch.com.mx)
Ritch, Mueller, Heather y Nicolau, S.C.