An extract from The Corporate Tax Planning Law Review – Edition 3
Mainly inspired by the BEPS Action Plan and maybe by the US influence, Mexico has introduced rules aimed to spot the true essence of transactions and tax them accordingly. Naturally, this has a direct impact on the way planning is done. Interestingly enough, Mexico is not shifting from a formalistic approach towards a substance approach. Rather, formal requirements now co-exist with substance requirements, and failure to comply with any of them may equally lead to contingencies. We discuss the most important measures recently introduced about substance and business reason.
The most important development within the Mexican tax system that may affect tax planning is a concept that has been in place for a long time in other jurisdictions, but in Mexico is rather a novelty, created by case law: materiality.
Materiality has become a standard necessary in proof of indispensability. Under this test, taxpayers must be able to demonstrate that a transaction resulting in an otherwise deductible expense has actually taken place, regardless of whether it is entered into their accounting records or documented in an invoice issued by the relevant supplier.3 In other words, proof must be given that the goods acquired or the services received are true, and they represent some economic value to the taxpayer.
It is important to mention that from an evidence standpoint, it is often difficult to prove materiality as there is no statutory, regulatory or judicial guidance to do so. This is particularly true in the case of services, where there may be little or no evidence of the human activity concerned, even if the result thereof may be physically recognised. For example, if a service provider repairs a given piece of machinery, but fails to provide a malfunction report or a report of repairs performed, there may be little or no evidence at all that the machinery was, in fact, repaired, and, therefore, payment in exchange thereof may become non-deductible.
Consistently with the materiality test, on 9 December 2019, amendments to the Federal Tax Code were enacted, including the first general anti-abuse provision, based on business purpose. Accordingly, any transaction that has a tax benefit (tax reduction, deduction, credit, non-taxation, etc.) but lacks a business purpose will be given the tax effects that would correspond to the legal transactions that would have been carried out to obtain a ‘reasonably expected economic benefit’ by the taxpayer, which, of course, must be other than a fiscal one.
Furthermore, the statute provides several rebuttable presumptions that lead to the conclusion that a given transaction has no business reason. For example, whenever the tax benefit achieved is greater than the economic benefit achieved with the transaction concerned.
In any case, however, such a conclusion may only be reached once a body composed of officials from the Ministry of Finance and the Tax Administration Service issues a favourable opinion, upon request of the corresponding examiner. Thereafter, the conclusion is notified to the taxpayer, so that he or she may be in a position to rebut it.
Nonetheless, this provision presents several challenges from an advisory standpoint, including the following: (1) there is no administrative or judicial experience with standards such as the ‘business reason’; (2) there is no guidance as to what the sort of evidence would be required to meet this standard; and (3) the body described above is likely to be composed of career officials with little or no experience in a business environment.
Thus, from a planning perspective, it is now paramount to document as much as possible the business needs leading to a given transaction, and the way in which the transaction is able to meet such needs.
i Entity selection and business operations
The current developments in Mexican taxation do not allow any fixed set of planning mechanisms. They depend on the facts and circumstances of each case, which also vary along with the passage of time, given the pace of the economy and technology, among other factors. Therefore, it would be impossible – and maybe futile – to address planning structures in particular.
First of all, to achieve efficiency in tax planning we need to first to keep in mind the parties subject to income tax. In Mexico, the parties subject to tax are all the individuals and legal entities in the following cases:
- Mexican residents: on all of their income, regardless of the location of the source of wealth of this income;
- foreign residents who have a permanent establishment in Mexico: on income attributable to the permanent establishment; and
- foreign residents: on income from sources of wealth located in Mexican territory, whenever they do not have a permanent establishment in Mexico; or when they have a permanent establishment and the income is not attributable to it.
Once established who is subject to taxation, it is important to mention that any Mexican entity is subject to the same tax regime, so the entity selection does not constitute a key step on tax planning in Mexico. Rather than focusing in the entity selection in Mexican tax planning, it is extremely important to focus on the source of the income.
Domestic income tax
To understand the elements that might have an impact within a tax structure we first need to understand the basics of Mexican corporate income tax, described below.
General tax regime
The tax regime established for the Mexican legal entities is provided by the Title II of the Income Tax Law (ITL). In general terms, these entities must calculate income tax by multiplying taxable income earned in a fiscal year by the 30 per cent rate, as shown below:
- (gross4 – deductions5) – employees’ profit-sharing paid in the fiscal year = tax profit;
- tax profit – tax loss carry fowards = taxable income; and
- taxable income x .30 = payable income tax.
Commonly, to achieve efficiency, taxpayers focus on deductible items and losses. To this end, however, it is necessary to consider general requirements and specific requirements, in addition to limitations, as described below.
Article 25 of the ITL provides a list of deductible items, such as rebates, cost of goods sold, net expenses, investments, non-performing credits and losses. However, any item must be strictly indispensable for the taxpayer’s activity in order to be deductible, pursuant to Article 27(I) of the same statute.
There is, however, no legal definition of the concept ‘strictly indispensable’. For this reason, case law has developed this concept. Indeed, the Mexican Supreme Court of Justice has interpreted this concept taking into account the purposes of each company and the specific expense in question, with the intention that the character of indispensable is linked to the achievement of the business purpose of each taxpayer.6
Thus, to determine whether the strict-indispensability test is fulfilled, the relevant expense must comply with the following three general elements:
- to be directly related to the taxpayer’s business purpose;
- to be necessary for the taxpayer’s activity or its development; and
- the lack thereof should result in a detriment to the taxpayer’s activity and development.
More recently, the courts have developed from the strict-indispensability test, an additional element to be fulfilled in order for an expense to be deductible: the materiality of the transaction, which has already been described.
Tax losses are sustained whenever deductions are greater than gross income. A tax loss sustained in a year may be carried forward to reduce the tax profit of the ten following years until it is depleted. No carry-back is allowed.
When in a given year a taxpayer fails to carry forward a tax loss, despite being able to do so, the taxpayer shall forfeit the right to do so in subsequent years up to the amount that could have been carried forward.
International taxThe ITL provides that foreign residents with no permanent establishment in Mexico earning items of income from Mexican sources of wealth may be subject to tax in this country. The source rules are set forth by the ITL as well. Furthermore, the applicable rate depends on certain factors, such as the sort of item of income concerned. In addition, such rate may be reduced or wiped out entirely by a tax treaty, when applicable.
It is important to note that quite often the ITL provides that the tax must be paid through withholding, which must be performed by the payer in the transaction concerned. In such cases, withholding appropriately becomes an important issue as failure to do so may render the relevant expense non-deductible, in addition to the fact that the tax authority may claim the deficiency from the withholding party, as it is deemed to be jointly and severally liable for that tax under the relevant provisions.
Therefore, when designing a transaction, it is of the utmost importance to determine whether the transaction yields income that may be deemed to arise from Mexican sources of wealth and if so, what would be the appropriate level of withholding.
Finally, in many jurisdictions, there are vehicles that may work quite efficiently for a number of purposes. For example, Spain has the ‘ETVE’. Likewise, Spain and other countries have ‘patent boxes’. From a Mexican perspective, however, it is important to make sure that those vehicles qualify as tax residents of the relevant jurisdiction when designing the relevant structure. Otherwise, Mexico could deny treaty benefits.
Likewise, it is important to analyse the tax treatment of such vehicles in their home country, as it may have an impact on the deductibility of any payments made to them by Mexican residents, under certain BEPS-related provisions recently enacted in Mexico.
Mexican tax legislation contains several rules governing and limiting the deduction of interests that have been introduced over the years to prevent abuses by taxpayers, including thin cap rules, rules on back-to-back loans (this concept will be developed in the cases Section of this chapter), and the newly enacted limit on 30 per cent of EBITDA, also heavily based on the BEPS Action Plan.
Thin cap rules
Thin cap rules substantially prevent taxpayers from deducting interests associated with debts contracted with related parties residing abroad, which exceed three times the stockholders’ equity.
To calculate the amount of the debts exceeding this threshold, the sum of the shareholders’ equity at the beginning and at the end of the year shall be divided by two. The quotient thereof shall be then multiplied by three, and the result shall be finally subtracted from the annual average balance of all the taxpayer’s interest-accruing debts.
If the annual average balance of the taxpayer’s debts entered into with foreign resident related parties is lower than the excess amount of the debts referred to in the preceding paragraph, no interest accrued on those debts may be deducted. If the annual average balance of the debts entered into with foreign resident related parties is greater than the aforementioned excess, interest accrued from the debts entered into with the foreign resident related parties shall not be deductible in an amount equal to the result of multiplying the interest by the factor obtained by dividing the excess by the balance.
The following interest-bearing debts are excluded from this limitation: those assumed by members of the financial system when performing transactions related to their purpose and those assumed for the construction, operation or maintenance of productive infrastructure related to strategic areas for the country or the generation of electric power.
Limit on 30 per cent of EBITDA
In 2020, Subsection (XXXII) to Article 28 of the ITL was introduced. Under this Subsection, the deduction of ‘net interest’ is limited to 30 per cent of the taxpayer’s adjusted taxable income. This limitation includes any type of financing, with the exception of public infrastructure and projects for the exploration, extraction, transportation, storage or distribution of oil and hydrocarbons, among others. This limitation is not applicable either to members of the financial system regarding the operations related to their business purpose, or to the productive companies of the state (for example, PEMEX and CFE).
The amount of net interest that is not deductible in one year may be carried forward for the following 10 years until it is exhausted, to the extent that taxpayers keep a record thereof. For these purposes, these concepts are defined as follows. Net interest for the year means the amount resulting from reducing to the total payable interest of the fiscal year, the total income from accrued interest within the fiscal year in question. This rule will not apply to a de minimis threshold of 20 million pesos of interest accrued during a tax year individually or as a group. The adjusted taxable income will be the amount that results from adding to the fiscal profit of the year its total interest expense accrued for the year plus the year’s total amount deducted for fixed assets, deferred expenses, deferred charges and disbursements made in preoperative periods.
This limitation is generally applicable in addition to and not in lieu of the other anti-avoidance rules described herein, either general or specific.
ii Common ownership: group structures and intercompany transactions
Articles 179 et al of the ITL provide that legal entities residing in Mexico that enter into transactions with a foreign resident related party must calculate their gross income and authorised deductions derived therefrom, using the prices or consideration that would have been agreed by independent parties in comparable transactions. Otherwise, the Mexican tax authority is empowered to reassess the income and deductions.
In other words, the arm’s-length standard must be met in related-party transactions. In order to determine the arm’s-length price, a functional analysis must be performed and certain transfer pricing methods must be used. The analysis and methods replicate those recommended by the OECD in its Transfer Pricing Guidelines for Tax Administrations and Multinational Enterprise to a very large extent.
Accordingly, whenever designing a given transaction between related parties that may result in some form of a tax reduction, careful attention must be given to making sure that the transaction is necessary and that it has a sound business purpose, as explained before, but also that the conditions agreed therein are consistent with the arm’s-length standard.
In this regard, the Mexican tax authority is increasingly scrutinising intra-group transactions to verify compliance with the arm’s-length standard with the associated risk of very large contingencies. Accordingly, when designing a structure, it is advisable to take a proactive approach by analysing the convenience of risk-mitigation strategies, such as requesting an advanced pricing agreement or even a bilateral advanced pricing agreement.
Ownership structure of related parties
When restructuring a group either within itself or for the purpose of bringing in new investors, it is of the utmost importance to consider that this reorganisation could seriously limit the use of an otherwise effective tax attribute used for planning purposes: losses.
In Mexico, the transmission of losses is highly regulated and limited, as it is considered that this sort of arrangement is one of the most typical ways in which otherwise profitable companies reduce their tax liabilities. Some of those limitations are described below.
Limitations in cases of spin offs and mergers
Tax losses of a company cannot be transferred to another entity, except in the case of merger and spin-offs.
In the event of a merger, the merging entity may use tax losses pending to be carried forward at the time of the merger only to offset tax profits from the same businesses in which the losses were sustained.
In spin-offs, if the original company primarily conducted commercial activities, tax loss carry-forwards shall be divided between the original company and the spun-off companies in proportion to the division of the total value of inventories and accounts receivable related to the commercial activities of the original company. Pursuant to the 2021 amendment, a spin-off may be considered a disposition of property despite the formal requirements necessary for not qualifying as such are met. Indeed, a spin off typically entails the transfer of some or all the assets, liabilities and equity of the original company to the new company or companies. Whenever, as a result thereof an item in the stockholders’ equity of any of the companies involved in the spin off concerned arises, which was not recorded or recognised in the stockholders’ equity accounts of the statement of financial position prepared, presented and approved at the general meeting of partners or shareholders that agreed to the spin-off of the company in question, a disposition of property shall be deemed to take place.
If the original company primarily conducted other entrepreneurial activities, the tax loss carry-forwards shall be divided between the original company and the spun-off companies in the proportion to the division of the fixed assets. To calculate the proportion referred to in this paragraph, investments in real property not related to the principal activity shall be excluded.7
Limitations in cases of change of control
In the case of a change in the partners or shareholders that control a company that has tax loss carry-forwards, and the sum of the company’s income in the three last years is less than the amount, updated for inflation, of those losses at the end of the last year before the change in partners or shareholders, the company may carry forward losses only to offset tax profits corresponding to the same business lines in which the losses were sustained. For these purposes, income declared in the financial statements for the period in question, approved by the shareholders’ meeting shall be considered.
A change of the partners or shareholders that control a company shall be deemed to exist when direct or indirect holders of more than 50 per cent of the voting shares or ownership interest of the company in question have changed, in one or more acts carried out in a period of three years8
This does not apply to changes of partners or shareholders as the result of an inheritance, donation, corporate reorganisation, or merger or spin-off not considered to be a transfer of property provided that, in the event of a reorganisation, merger or spin-off, the direct or indirect partners or shareholders that controlled the company prior to said acts continue to do so afterwards.
Undue transmission of losses
The authority may presume that an undue transmission of tax losses was made when, during the analysis of information from its databases, it finds that the taxpayer who sustained the losses was part of a restructuring, spin-offs or merger, or underwent a change in shareholders, and as a result, this taxpayer ceases to be part of the group it used to belong to. This rebuttable presumption shall be available whenever the taxpayer that sustained the losses meets one of the following conditions:
- tax losses sustained in any of the three tax years following incorporation are greater than assets, and more than half of its deductions resulted from transactions with related parties;
- tax losses sustained after the three tax years following incorporation, derived from the fact that more than half of its deductions come from transactions between related parties, and they have increased by more than 50 per cent compared to those incurred in the tax year immediately preceding;
- a reduction in more than 50 per cent in its physical capacity to perform its main activity in the tax years subsequent to the year in which a tax loss is sustained, as a result of the transfer of all or part of its assets through restructuring, a spin off or merger, or because these assets were transferred to related parties;
- whenever losses are sustained, and there is a transfer of property, which includes the segregation of property rights, without considering whether the segregation was taken into account while determining the cost of acquisition;
- whenever losses are sustained and there is a change in the depreciation rate of investments under the ITL, before at least 50 per cent of the investments is depreciated; and
- whenever losses are sustained and there are deductible items whose corresponding consideration was secured with negotiable instruments, and this debt was extinguished through means other than those set forth in the ITL.9
In any of those cases, opportunity will be given to taxpayers to rebut this presumption, although from an advisory perspective it is advisable to take a proactive approach rather than a reactive approach.
International intercompany transactions
Mexican legislation has very strict and specific rules involving tax havens and transparent entities, so it is important to analyse while developing a tax structure whether the planned transaction renders income subject to preferential tax regimes.
In this regard, is important to mention that income subject to preferential tax regimes shall be income not subject to tax abroad or subject to an income tax lower than 75 per cent of the income tax that would be triggered and paid in Mexico (30 per cent rate).
In those cases, there is also a rebuttable presumption that transactions between Mexican residents and corporations or entities subject to a preferential tax regime are made between related parties at conditions inconsistent with the arm’s-length standard.
In addition, income earned from Mexican sources of wealth by foreign persons residing in preferential tax regimes that are related to a Mexican resident payer shall be subject to a 40 per cent withholding rate on a gross basis.
Therefore, when dealing with preferential tax regimes (tax havens), it is necessary to consider that the expense associated with a given transaction may not be deductible if the parties concerned fail to rebut the presumption that this transaction is inconsistent with the arm’s-length standard. Furthermore, it is necessary to take into account that the highest possible withholding rate under the ITL may be applied to this sort of transaction.
In addition, from 2021, there are new rules for transparent entities and legal concepts as provided in the 2020 tax reform. According to the new rules, the tax transparency of the entities and concepts is not recognised for tax purposes in Mexico and, as a consequence, those items would be treated as if the payments received by such tax transparent entities and concepts were earned by them, rather than by their shareholders or members.10
Considering that one of the most important actions that needs to be carried out is to analyse structures that involve transparent entities or legal concepts with nontransparent entities and identify that if this new regime is to apply, whether or not it is subject to a tax haven.
iii Third-party transactionsSales of shares or assets for cash
In cases of dispositions of shares or securities that represent the ownership of assets, the source of wealth shall be considered to be located in Mexican territory when the person who issued the shares or securities is a Mexican resident or when more than 50 per cent of the accounting value of the shares or securities derives directly or indirectly from real properties located in the country. The tax shall be calculated by applying the 25 per cent rate to the total amount of the transaction, without any deductions. In certain cases, however, taxpayers may elect to be taxed at the 35 per cent rate on the gain.
In cases where a buyer may elect between buying shares or the underlying assets, the interests of the parties must be balanced.
The seller, for example, will want to sell whatever has a higher basis, to detonate a lower profit. The buyer, conversely, should consider that if he or she buys shares, the purchase price cannot be deducted and it must become part of the cost of the shares for a subsequent sale, while an investment in assets would generally be deductible.
In those cases, it is also necessary to consider that a sale of shares would certainly entail that the companies’ contingencies would be tagged alone, while it might not be the case in an asset deal, despite the fact that the Mexican tax law provides that purchasers of going concerns may be held jointly and severally liable for previous tax liabilities.
Tax-free or tax-deferred transactions
Only in the case of reorganisations of corporations that belong to the same group, the tax authorities may authorise the deferral of the tax payment for the gain on the disposition of shares within the group. In these cases, the deferred tax shall be paid within the 15 days following the date on which a subsequent disposition is carried out resulting in the exclusion from the group of the shares referred to in the corresponding authorisation, and the payment shall be updated from the time it was incurred until it is made. The disposition value of the shares that must be considered to calculate the gain shall be the value that would have been used between independent parties in comparable transactions or the value indicated by an appraisal practiced by the tax authorities.
The authorisation shall only be granted before the reorganisation, provided that the consideration stemming from the disposition consists solely of an exchange of shares issued by the corporation that purchases the shares being transferred, and provided that the purchaser and transferor are not subject to a preferential tax regime and do not reside in a country with which Mexico does not have a broad agreement for the exchange of tax information.
We must note, however, than certain tax treaties afford exemptions in cases of corporate reorganisations within the same group where no cash consideration is paid. As a result, the deferral under the statute should be considered a solution of last resort.