Eyeing Mexico’s Energy Sector? Mind the Tax Laws

As Mexico continues to open up the previously government-owned energy sector to foreign investors, there are a number of variables for U.S. PE firms to consider.

As Mexico opened its energy companies up to foreign investors, some tax challenges surfaced that many private equity buyers in the U.S. may not have thought about.

A primary issue, from the U.S. perspective, is what kind of tax structure the investor wants to use: flow-through or deferral. Meril Markley, senior director at RSM US LLC, who talks through such issues with clients, says that misunderstanding the ins and outs of these taxes is common.

In a flow-through structure, income earned in Mexico is taxed in Mexico but recognized in the U.S. for a foreign tax credit. And because the foreign tax rate in Mexico is 30 percent and the rate in the U.S. is 35 percent, Markley says it’s most likely that the private equity firm’s portfolio company would be paying some incremental tax in the U.S. The alternative is the deferral structure, which is not recognized in the U.S. until a dividend is received.

One of the “key issues that a lot of companies get wrong” when they invest in companies in Mexico’s energy sector is failing to avoid the pitfalls of the two shareholder minimum requirement for Mexican companies. As there is effectively no minimum for the second shareholder (a small number of shares are often given to an employee), what are considered two shareholders in Mexico are one shareholder from a U.S. perspective.

“You end up in Mexico with two shareholders for U.S. purposes, but you really have 100 percent ownership,” says Markley. She adds that it’s important how this is done, because Mexico instituted a dividend holding tax, which is reduced to a 5 percent rate if the owner holds at least 10 percent of the shares.

While PE firms always conduct due diligence into companies they’re considering bringing into their portfolio, there are some extra issues that could pop up when it comes to energy companies in Mexico. “The first question the U.S. investor needs to ask is whether they require shares or require assets,” Markley says. “Typically, the seller wants to sells shares and the buyer wants to buy assets to leave behind liability, whether they’re exposed or unexposed.” Other issues to watch for, she adds, are payroll-tax liability and mandatory employee profit-sharing.

Mexico is at the forefront of electronic tax compliance, Markley notes. It’s difficult to evade taxes in Mexico, thanks to governmental reforms, and there’s “a whole new level of very detailed disclosure to tax authorities in auditing companies down the road,” she says. “It’s a very different new system of requirements for Mexican taxpayers. It’s an effort to continue transparency in corporate tax matters and to discourage taxpayers from undertaking transactions that are not reportable.”

It’s important to note one interesting thing about the energy reforms in Mexico, which opened the country to foreign investors: The action triggered a lot of interest in investments but hasn’t actually changed the tax system. Those two sets of reforms happened independent of each other, says Markley.

“If they haven’t invested in Mexico before, they’re probably not aware,” she says. “Since opening [the country to foreign investors], a lot more U.S. companies are dipping their toe in the water and are not aware of the ins and outs. We’re demystifying the process of investing in Mexico.”