Positive Amendments to the Mexican FIBRA E Tax Regime

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Buck Burke
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1 Santiago Diaz Rivera / Enrique Perez Grovas Latin American Business Center International Tax Services Ernst & Young LLP Positive Amendments to the Mexican FIBRA E Tax Regime With the liberalization of Mexico s energy sector to private investment in late 2013, after 75 years of state monopoly, the need to devise efficient ways to finance energy and infrastructure projects has become a pressing matter. The dramatic drop in oil prices, along with the recent devaluation of the Mexican peso, dealt an important blow to Mexico s public revenue and pressured the Mexican government to come up with new investment alternatives that could shift the capital needs of energy and infrastructure projects from the public budget to the private sector. Moreover, the Mexican government has been eager to find a way to make up for cutting the budget of state owned companies Petróleos Mexicanos (Pemex) and the Comisión Federal de Electricidad (CFE), without having to raise debt levels. As a result, on September, 2015, Mexico s Ministry of Finance launched the FIBRA E. This vehicle was created to provide capital through the public markets to Mexican companies that carry out certain exclusive activities 1 and own assets that generate cash flows that are reasonably stable and predictable, while allowing such companies to maintain operational control of the assets. The FIBRA E was conceived having in mind the Master Limited Partnerships ( MLPs ) in the United States, which have been publicly traded since the early 1980s, but adapting it to the Mexican tax regime. The FIBRA E tax regime is based on the tax provisions that govern real estate FIBRAS (Mexican real estate investment trusts), which were tailored to the needs of the FIBRA E through temporary tax regulations. As opposed to real estate FIBRAS, where the qualifying assets are held directly by the issuing trust, in the case of the FIBRA E, a legal entity commonly known as a Promoted Company must be the owner of the assets. The FIBRA E is a shareholder of the Promoted Companies. A significant challenge in the conception of the FIBRA E tax regime was to achieve tax transparency for the Promoted Companies for income tax purposes, which allows the income obtained by Promoted Companies to flow through and be taxed in the hands of its shareholders, rather than being taxed at the corporate level in the Promoted Companies as a regular Mexican corporation would normally be. As such, a Promoted Company is not considered an income taxpayer per se as it must determine its yearly tax result and then allocate it among its shareholders on a proportional basis. In turn, the FIBRA E, 1 Mainly activities related to the oil and gas midstream and downstream sectors, the generation, transmission and distribution of electricity or infrastructure projects under government concessions.

2 as a shareholder of the Promoted Companies, must determine its own yearly tax result by consolidating the income obtained from the Promoted Companies in which it participates. The FIBRA E must distribute 95% of its tax result every year. Investors are taxed on the portion of the tax result distributed to them by the FIBRA E according to their participation. These rules, as introduced last year, laid a solid legal framework for the FIBRA E, but had been perceived by the industry as lacking certain technical adjustments that would persuade Mexican companies to finally take the plunge. On April 1, 2016, the tax authorities issued amendments to the FIBRA E rules. The most relevant changes included the possibility for the shareholders of a Promoted Company to defer capital gains obtained upon transferring such company to the FIBRA E (to the extent that they receive FIBRA E certificates as consideration), the broadening of the definition of new assets that can be owned by a Promoted Company and the introduction of a new reorganization rule for the drop-down of a Promoted Company s shares into another Mexican entity, among others. These new rules have been generally perceived by the industry as a step in the right direction, and show that the tax authorities are being open to dialogue and receptive to the industry s needs, confirming their intention to promote this vehicle as one of the key instruments to finance Mexican energy and infrastructure projects. The expectation from the markets was to have the first FIBRA E go public by the end of the second quarter of 2016, which now seems unlikely. With Pemex and CFE being two of the largest companies in the country with qualifying assets, and having reported massive losses during 2015, the expectation is that they should be the first in line to launch a FIBRA E, hopefully within the second half of this year, but only time will tell. Below is a brief summary of the most relevant changes to the FIBRA E tax regime. While this is a general overview of the most significant changes, it should be noted that there were other amendments that are not being analyzed herein. Deferral of capital gains on contribution of shares of Promoted Companies to FIBRA E The shareholders ( Sponsors ) of an entity whose shares are transferred fully or partially to a FIBRA E ( Promoted Company ) must determine a taxable gain or loss as if they were selling assets instead of shares. In order to determine such gain or loss, the Sponsors must compare the tax basis of the assets being transferred with their sales price (which must meet fair market value conditions and must be added with the proportional debt incurred by the Promoted Companies for their acquisition). The tax gain or loss obtained on the transfer of the shares of a Promoted Company must be recognized by the Sponsors on the same fiscal year of the transfer. One of the key changes to the FIBRA E tax regime is the possibility for the Sponsors to obtain a deferral on the capital gains triggered upon transferring the shares of a Promoted Company into a FIBRA E structure, in the proportion that the sales price is covered through the issuance of FIBRA E certificates ( CBFEs ) as consideration.

3 The sale price of the shares of the Promoted Company being transferred that were paid through CBFEs shall be divided by the total price of the transfer of shares to the FIBRA E. The ratio obtained shall then be multiplied by the total gain determined on the transfer of shares to the FIBRA E, and the result will be the deferred gain for the Sponsors. The deferred gain should be allocated per CBFE received as consideration. Sponsors shall recognize as taxable income an amount equal to 15% of the deferred taxable gain at the end of each fiscal year, including the year in which the shares were transferred, until the total amount is depleted. The deferred tax would be triggered if: (i) the CBFEs obtained by the Sponsors in the transfer of the shares of a Promoted Company are subsequently transferred; (ii) the shares of such Promoted Company are transferred by the FIBRA E; or (iii) the Promoted Company transfers the assets that gave rise to the deferral. This amendment is meant to provide symmetry, as the FIBRA E tax regime as it was originally introduced allows a tax deduction at the level of the FIBRA E through the amortization at a yearly 15% rate of a deferred expense for up to the amount of any gain obtained by the Sponsors upon transferring the shares of a Promoted Company to the FIBRA E; or instead, in case a tax loss is triggered upon the transfer of the shares to the FIBRA E, a deferred gain must be recognized as taxable income at an annual rate of 15%. Broadening of Exclusive Activities for Promoted Companies In order to qualify for the FIBRA E tax regime, at least 90% of a Promoted Company s annual taxable income should derive from certain exclusive activities, mainly related to the oil and gas midstream and downstream sectors, the generation, transmission and distribution of electricity, infrastructure projects under government concessions or the management of FIBRA E trusts. The amended rules included as exclusive activities the treatment, blending, processing, conversion, and transportation of oil products, petrochemicals or any other products derived from oil or natural gas, except for the sale, marketing and end-sale of these products to the public. Hydrocarbon transportation, storage and distribution activities are now also considered exclusive activities, even if they are carried out within the perimeter of a contractual area or assignment area, provided such activities are not carried out under a contract or an assignment. New Assets Another requirement to qualify for the FIBRA E tax regime is that no more than 25% of the accounting value of a Promoted Company s non-monetary assets, in any given year, can be invested in new assets. To this end, the FIBRA E rules, as originally issued, defined new assets as those that had less than 12 months since their acquisition and start of operations in Mexico. The amended rules clarified that the determination of whether assets are considered new depends solely on whether such assets have been operating in Mexico for more than 12 months, regardless of the date that the Promoted Company acquired them.

4 Additionally, the amended rules set forth that, subject to prior approval from the tax authorities, the following investments should not be considered new assets: - Assets acquired or built within the normal course of the operations of a Promoted Company and whose purpose is to repair, adapt or replace assets or when these stop being useful for generating income; - Assets acquired or built to comply with the obligations contracted under a concession to carry out exclusive activities related to infrastructure projects, or, when applicable, to exercise the rights derived from or related to such title, provided that the Promoted Company has been the concessionaire of such concession for at least 12 months before carrying out such investments; and - Investments in assets through which a Promoted Company has developed exclusive activities related to hydrocarbons or electricity for at least a period of 12 months, provided such additional investments are considered part of the same permit granted by the Energy Regulatory Commission (CRE). Capital Contribution Account Pursuant to the amended rules, trustees of the FIBRA E are now required to maintain a capital contribution account ( CUCA ) to keep track of the contributions received either in cash or in kind (including shares of a Promoted Company contributed by a Sponsor), as well as of the capital reimbursements paid by the FIBRA E to the holders of the CBFEs. The CUCA of the FIBRA E must be maintained on a global basis, instead of having separate accounts per CBFE holder. Distributions to the CBFEs holders exceeding the FIBRA E s tax result are considered capital reimbursements and must decrease the balance of the FIBRA E s CUCA. If the balance of the CUCA is depleted, distributions exceeding the FIBRA E s tax result must be recognized as taxable income by the holders of the CBFEs, according to the tax regime applicable to each CBFE holder. If a distribution to the holders of the CBFEs is considered a capital reimbursement, the tax basis of the CBFEs must be decreased in the same amount as the capital reimbursement corresponded to each CBFE, regardless of the nominal value at which such CBFEs were issued. New Reorganization Rule for the Drop-Down of a Promoted Company s Shares A new rule was included whereby, subject to prior approval from the tax authorities, the transfer of shares issued by an entity that holds assets related to exclusive activities (i.e. a Promoted Company) to a Mexican entity would not be considered a sale of shares for tax purposes, if the following requirements are met: - The shares of the Promoted Company are contributed to an entity that is a tax resident in Mexico and whose first capital contribution is the contribution of such shares; - In a maximum period of six months from the date the contribution of the shares is made, a FIBRA E acquires at least 2% of voting shares of the shares of the Promoted Company; - Immediately prior to the acquisition of the shares by the FIBRA E, the entity whose shares are being transferred meets all the requirements to qualify as a Promoted Company; and

5 - The Mexican entity receiving the shares of the Promoted Company issues shares as consideration for the total value of the shares of the Promoted Company to the entity that contributed them. If any of the above requirements is not met, the transfer of shares would be considered a sale for tax purposes from the moment the contribution was formalized. Reorganization pursuant to Spin-off According to the FIBRA E rules as originally issued the spin-off of a Mexican entity, whereby assets related to exclusive activities are transferred to a spun-off entity (i.e. a Promoted Company), was not considered a sale of goods for Mexican tax purposes provided that at least 5% of the shares issued by the Promoted Company were acquired by a FIBRA E trust that complies with the FIBRA E requirements, within 6 months from the date on which the spin-off is effective. The amended rules reduce the percentage of the shares of the Promoted Company that must be acquired by a FIBRA E within 6 months of the spin-off from 5% to 2%, and also clarify that the shares that can be acquired to meet this requirement are both the shares of the spun-off entity (i.e. Promoted Company) or those of the company that underwent the spin-off. Buy-back of CBFEs by FIBRA E FIBRA E trusts are now allowed to buy back a portion of its CBFEs, to the extent that the funds used for such purposes came from the profits that the FIBRA E was not required to distribute (5% of the tax result of each year). In general terms, the amount of the CBFEs repurchased may not exceed 5% of the outstanding CBFEs of the FIBRA E and must be put back on the market within a year from the date of the repurchase. The investment held by a FIBRA E in its own CBFEs is considered to be an authorized investment 2 to the extent that the total investment in CBFEs, Mexican government securities and shares of debt-related mutual funds does not exceed 30% of the annual average value of the trust s property and that the FIBRA E considers the returns on such investments for purposes of determining its tax result. Key Takeaways The amendments to the FIBRA E tax regime are positive, they show that the Mexican tax authorities are being open to dialogue and truly intend to promote this vehicle as one of the cornerstones for financing Mexican energy and infrastructure projects. With the first Fibra E still pending to go public, the tax authorities should remain receptive to the industry s demands and continue to be proactive in adapting legislation as practical issues arise when the first FIBRA E is finally launched. 2 At least 70% of the annual average net worth of a FIBRA E must be invested in shares of Promoted Companies. The remainder must be invested in securities issued by Mexico s Federal Government and registered at the National Securities Registry, or in shares of debt-related mutual funds.

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More publications l l Subscribe Tax Consulting More publications l www.chevez.com l Subscribe 2016 1 Tax Consulting Amendments to the FIBRA-E rules Today was published in the Federal Official Gazette the First Amendment to the Miscellaneous Tax Resolutions