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Local developments

Influenced by the BEPS Action Plan and the US, Mexico has enforced rules meant to spot the true essence of transactions and tax them accordingly. These rules have a direct impact on the way tax planning is carried out. Interestingly enough, Mexico is not shifting from a formalistic approach to a substance approach. Formal requirements now coexist with substance requirements, and failure to comply with any of them might equally lead to contingencies. These recently introduced measures on substance and business requirements are further described below.

The most significant development in the Mexican tax system that might affect tax planning is the materiality concept created by case law that has been in place in other jurisdictions for a long time but is rather novel in Mexico.

Materiality has become a standard necessity in proof of indispensability. Taxpayers must be able to demonstrate that a transaction resulting in an otherwise deductible expense has taken place, regardless of whether it is entered into their accounting records or documented in an invoice issued by the supplier.3 In other words, taxpayers must submit proof that the goods acquired or the services received are truthful, and they must also submit proof of their economic value to the taxpayer. It is often challenging to prove materiality from an evidence standpoint as there is no statutory, regulatory or judicial guidance. This materiality is particularly true for services where there might be little or no evidence of the activity, even if the result thereof might be physically tangible. For example, if a service provider repairs a given piece of machinery but fails to provide a malfunction or repairs report detailing the repairs performed, any payment in exchange thereof might become non-deductible.

On 9 December 2019, amendments to the Federal Tax Code were enacted, including the first general anti-abuse provision based on business purposes. Accordingly, any transaction that has a tax benefit (tax reduction, deduction, credit or non-taxation, etc.) but lacks a business purpose will incur tax effects corresponding to legal transactions that were carried out by the taxpayer to gain a reasonably expected economic benefit; in other words, tax benefits are targeted for transactions that have a tax purpose in mind. As a result of the 2022 tax reform, the business purpose concept has been enacted explicitly as the ultimate test to back-to-back loans, corporate restructures and thin capitalisation ('thin cap').

As amended in the 2020 tax reform, the statute establishes several rebuttable presumptions that conclude when a given transaction has no business reason. For example, whenever the tax benefit of a transaction is greater than the economic benefit received, these presumptions apply.

In any case, this conclusion may be reached only at the request of the corresponding examiner, once a body of officials from the Ministry of Finance and the Tax Administration Service issues a favourable opinion. The officials then notify the taxpayer of their conclusion so that the taxpayer may rebut it.

Nonetheless, this provision presents several challenges from an advisory standpoint, including that (1) there is no administrative or judicial experience on 'business reason' standards, (2) there is no guidance as to what evidence will be required to meet this standard, (3) the above-mentioned body of officials is likely to be constituted by career officials with little or no experience in a business environment and (4) there is little understanding of how the rules in force since 2020 will coexist with those enforced in 2022.

From a planning perspective, it is now paramount to document the business needs that lead to a given transaction and how the transaction can, to the extent possible, fully meet these needs.

i Entity selection and business operations

As a result of the fast-paced technological and economic sectors, current developments in Mexican taxation largely vary with time, do not allow any fixed set of planning mechanisms and mostly depend on the facts and circumstances of each particular case. Therefore, it is impossible – and maybe futile – to address planning structures in particular.

First of all, to achieve tax planning efficiency, we need to consider parties subject to income tax. In Mexico, all the following individuals and legal entities are subject to income tax:

  1. Mexican residents: all income is subject to tax regardless of the location of the source of wealth;
  2. foreign residents who have a permanent establishment in Mexico: all income attributable to any permanent establishment they have in Mexico; and
  3. foreign residents: all income attributable to sources of wealth located in Mexican territory if they do not have a permanent establishment in Mexico, or when they have a permanent establishment in Mexico and the income is not attributable to those sources of wealth.
Entity forms

The taxpayer subject to taxation must be defined, and any Mexican entity subject to the same tax regime must be mentioned. In Mexican tax planning, it is essential to focus on the source of income rather than on entity selection. Despite most entities being subject to the general tax regime, the sources of income treatment is substantially different and also fundamental for the taxation of individuals and corporations.

Domestic income tax

To understand the elements that might impact a tax structure, we first need to be acquainted with the fundamental aspects of Mexican corporate income tax, as are further described below.

General tax regime

The tax regime for Mexican legal entities is outlined in 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 a 30 per cent rate, as shown below:

  1. (gross4 minus deductions5) minus employees' profit sharing paid in the fiscal year equals tax profit;
  2. tax profit minus tax loss carry-forwards equals taxable income; and
  3. taxable income multiplied by 0.3 equals payable income tax.

Commonly, to achieve efficiency, taxpayers focus on deductible items and losses. It is necessary to consider general requirements, specific requirements and limitations, as described below.

Deductions

Article 25 of the ITL establishes 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 to be deductible, pursuant to Article 27(I) of the same statute.

There is, however, no legal definition of 'strictly indispensable'. For this reason, case law created this very concept. To level up, the Mexican Supreme Court of Justice has reinterpreted this concept considering the business purposes of each company and the specific expense in question, linking the indispensability to the fulfilment of the business purpose of each taxpayer.6

To determine whether an expense is strictly indispensable, it must comply with the following three general elements:

  1. be directly related to the taxpayer's business purpose;
  2. be necessary for the taxpayer's activity or its development; and
  3. the lack thereof should result in a detriment to the taxpayer's activity and development.

More recently, the courts developed an additional element to the strict indispensability concept called the materiality of the transaction so an expense may qualify as deductible.

Losses

Tax losses occur whenever deductions are higher than the gross income of any given economic activity. A tax loss sustained in a year may be carried forward to reduce the taxable profit of the 10 following years until it is depleted. No carry-back is allowed.

If, 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 tax

The ITL establishes that foreign residents with no permanent establishment in Mexico earning income from Mexican sources of wealth may be subject to tax. The source rules are set forth by the ITL as well. Furthermore, the applicable rate depends on certain factors, such as the item of income concerned. In addition, the rate may be reduced or wiped out entirely by a tax treaty, when applicable.

It is important to highlight that the ITL quite often requests that the tax must be paid by the taxpayer through withholding in the transaction. In such cases, withholding effectively becomes a vital issue, as failure to do so might render the relevant expense non-deductible. In addition, the tax authority may claim 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 yielded income may be considered a Mexican source of wealth and, if so, what is the appropriate withholding amount. Many jurisdictions have vehicles that might work quite efficiently for several purposes. For example, Spain has foreign securities holding entities (ETVEs), which are tax-efficient international investments structures. Likewise, Spain and other countries have 'patent boxes'. From a Mexican tax perspective, it is vital to ensure that the tax vehicles qualify for the relevant jurisdiction when designing the relevant structure. Otherwise, Mexico could deny treaty benefits.

Likewise, it is important to analyse the tax treatment of these vehicles in their home country because they may impact the deductibility of any payments made to them by Mexican residents under certain BEPS-related provisions recently enacted in Mexico.

Capitalisation requirements

Mexican tax legislation outlines several rules governing and limiting the deductibility of interests that have been incurred over the years to prevent taxpayer abuse, including thin cap rules, rules on back-to-back loans (this concept is further described in Section IV of this chapter) and the newly enacted limit on 30 per cent of earnings before interest, taxes, depreciation and amortisation (EBITDA), also heavily based on the BEPS Action Plan.

Thin cap rules

Thin cap rules substantially prevent taxpayers from deducting interest associated with debts contracted with related parties residing abroad that exceeds three times the stockholders' equity.

To calculate the debt amount exceeding this threshold, the sum of the shareholders' equity at the beginning and the end of the year shall be divided by two. The quotient thereof shall then be multiplied by three, and the result shall be subtracted from the annual average balance of all the taxpayer's interest-accruing debts.

No interest accrued on those debts may be deducted 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. If the annual average debt balance entered into with foreign-resident related parties is greater than the aforementioned excess, debt interest accrued 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:

  1. debts assumed by members of the financial system when performing transactions relating to their purpose; and
  2. debts assumed for the infrastructure construction, operation or maintenance related to strategic areas for the country or the generation of electric power.
Limit on 30 per cent of EBITDA

Subsection XXXII of Article 28 of the ITL was enforced in 2020. Under this subsection, the 'net interest' deduction is limited to 30 per cent of the taxpayer's adjusted taxable income. This limitation includes any financing that does not qualify as public infrastructure and projects for the exploration, extraction, transportation, storage or distribution of oil and hydrocarbons, among others. This limitation does not apply to members of the financial system regarding operations relating to their business purposes, or the production carried out by state companies (e.g., Pemex and CFE).

The net interest amount that is not deductible in one year may be carried forward for the following 10 years until it is depleted, to the extent that taxpayers keep a record thereof. For these purposes, these concepts are outlined as follows: net interest for the year means the amount resulting from reducing the total payable interest of the fiscal year and the total income of the accrued interest within the fiscal year in question. This rule will not apply to a de minimis threshold value, a threshold for the value of shipped goods or a threshold of 20 million Mexican pesos of interest accrued individually or as a group during a tax year. The adjusted taxable income will be the addition of the fiscal profit of the year, its total interest expense accrued for the year and the year's total amount deducted for fixed assets, deferred expenses and charges, and disbursements made in preoperative periods.

This limitation is generally applicable in addition to, and not in lieu of, the other general or specific anti-avoidance rules described herein.

ii Common ownership: group structures and intercompany transactions

Article 179 et seq. of the ITL outline that legal entities residing in Mexico that enter into transactions with a foreign-resident related party must calculate their gross income and deductions therefrom, using the prices or consideration that would have been established by independent parties in comparable transactions. Otherwise, the Mexican tax authority is empowered to reassess income and deductions.

In other words, the arm's-length standard must be adhered to in related-party transactions. 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 largely replicate the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

Accordingly, when designing a transaction between related parties that might result in a tax reduction, careful attention must be given to make sure that the transaction is necessary and that it has a sound business purpose, as explained before, but also that the conditions established 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 a bilateral advanced pricing agreement.

Ownership structure of related parties

When restructuring a group either internally or externally to bring 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 for planning purposes: losses.

The transmission of fiscal losses is highly regulated and limited in Mexico, as this 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 mergers 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 of those losses.

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 by dividing the total value of inventories and accounts receivable related to the commercial activities of the original company. According to the 2021 amendment, a spin-off is considered a disposition of property despite the formal disqualification requirements. A spin-off typically entails the transfer of some of or all the assets, liabilities and equity of the original company to the new company or companies. A disposition of property occurs whenever an item in the stockholders' equity accounts of any of the companies involved in the spin-off was not recorded or acknowledged in the financial statements prepared, submitted and approved at the general meeting of the partners or shareholders who agreed to the spin-off of the company in question.

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 original company's principal activity shall be excluded.7

Limitations in cases of change of control

If there is a change in the partners' or shareholders' control of a company that has tax loss carry-forwards, and the sum updated for inflation purposes of the company's income in the previous three years is less than the amount of those losses at the end of the year before the partner or shareholder change, the company may carry forward losses only to offset tax profits corresponding to the same business lines of losses. 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 control of a company by partner or shareholder is the change of direct or indirect holders of more than 50 per cent of the voting shares or ownership interest of the company in one or more acts carried out in three years.8

In the event of a reorganisation, merger or spin-off, these limitations do not apply to changes of partners or shareholders as the result of an inheritance, donation, corporate reorganisation, merger or spin-off not considered to be a transfer of property, provided that the direct or indirect partners or shareholders that controlled the company prior to those acts continue to do so afterwards.

Undue transmission of losses

The authority may presume that an undue transmission of tax losses took place if, during the analysis of its databases, it finds that the taxpayer acted as part of a restructuring, spin-off 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 of such losses meets one of the following conditions:

  1. tax losses in any of the three tax years following its incorporation are greater than its assets, and more than half of its deductions resulted from transactions with related parties;
  2. tax losses in any of the three tax years following its incorporation, derived from the fact that more than half of its deductions arise from transactions between related parties, and they have increased by more than 50 per cent compared with those incurred in the immediately preceding tax year;
  3. a reduction of more than 50 per cent of its physical capacity to perform its main activity in the tax years after the year in which a tax loss was incurred, as a result of the transfer of all or part of its assets through restructuring, a spin-off or a merger, or if these assets were transferred to related parties;
  4. whenever losses and the segregation of property rights are incurred and there is a transfer of property and the segregation was not considered while determining the cost of acquisition;
  5. whenever losses are incurred 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
  6. whenever losses are incurred 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

If any opportunity is given to taxpayers to rebut this presumption 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 vital to analyse whether the planned transaction makes an income subject to preferential tax regimes while developing the tax structure.

It is important to mention that income subject to preferential tax regimes shall not be subject to tax abroad or an income tax lower than 75 per cent of the income tax that would be incurred and paid in Mexico (30 per cent rate).

In those cases, there is also a rebuttable presumption of the arm's-length standard that establishes inconsistencies of transactions between Mexican residents and corporations or entities that are subject to a preferential tax regime between related parties.

In addition, income earned from Mexican sources of wealth by foreign persons residing in Mexico with preferential tax regimes relating to a Mexican-resident payer shall be subject to a 40 per cent withholding rate on a gross income basis.

Therefore, when dealing with preferential tax regimes (tax havens), the expense associated with a given transaction may not be deductible if the concerned parties fail to rebut the presumption that this transaction is inconsistent with the arm's-length standard. Furthermore, it is necessary to consider that the highest possible withholding rate under the ITL may be applied to this sort of transaction.

In addition, new rules for transparent entities and legal concepts outlined in the 2020 tax reform were introduced in 2021. According to the new rules, the tax transparency of entities and concepts is not recognised for tax purposes in Mexico. As a result, payments received by these tax-transparent entities and concepts will be considered earned by the entities and concepts, rather than by their shareholders or members.10

The important courses of action are to (1) analyse and identify the structures that involve transparent entities or legal concepts with non-transparent entities, (2) determine whether this new regime is to apply and (3) determine whether it is subject to a tax haven.

iii Third-party transactionsSales of shares or assets for cash

The source of wealth shall be deemed 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 is located in the country for disposition of shares or securities that represent the ownership of assets. 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 choose to be taxed at the 35 per cent rate on the gain.

If a buyer is allowed to elect between buying shares or the underlying assets, the interests of the parties must be balanced.

By way of example, the seller will want to sell whatever has a higher basis to deduct a lower profit. Conversely, the buyer should consider that if they buy shares, the purchase price cannot be deducted, and it must be part of the shares' cost for a subsequent sale, whereas asset investments generally would be deductible.

It is also necessary to consider that the sale of shares would certainly result in the companies' contingencies to be tagged alone. Although Mexican tax law establishes that purchasers may be held jointly and severally liable for previous tax liabilities, this might not be the case in an asset deal.

Tax-free or tax-deferred transactions

As for reorganisations of corporations that belong to the same group, the tax authorities may authorise the deferral of the tax payment to gain the disposition of shares within the group. In these cases, the deferred tax must be paid within 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. The payment shall be updated from the time it was incurred until it is made. The disposition value of the shares must be considered to calculate the gain that would otherwise have been used between independent parties in comparable transactions or as the value indicated by an appraisal practised by the tax authorities.

The authorisation shall be granted only 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, that 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.