The Mexican Supreme Court of Justice (the Court) issued a judgment at the meeting thereof held on March, 2014 whereby there was an analysis of the interpretation of Article 32, Section XVIII of the Mexican Income Tax Law ("MITL ") in effect until the year 2013 (currently Article 28, Section XVIII) which sets forth the prohibition to deduct pro rata expenses incurred abroad with persons that are not income tax payers in Mexico pursuant to Titles II (legal entities) or IV (individuals) of the MITL.
The facts giving rise to the dispute resolved by the judgment issued by the Court mainly consisted of the following: a company that is a taxpayer in Mexico and part of a multinational group deemed as deductible a prorated expense derived from legal services provided by international advisors owing to the processes to acquire a business of insecticides in different jurisdictions, including Mexico.
The company that is the claimant raised, among other issues, that given the nature of the expense, it was impossible to determine the extent of services provided exclusively to Mexico, whereupon the expenses corresponding to the fees of each international advisor were reimbursed to the headquarters by each of the subsidiaries of the group that were involved in the acquisition of the business, depending on the value paid for that acquisition in each jurisdiction with respect to the total price of the global transaction that was set forth in a Master Purchase Agreement.
In this regard and for the analysis contained herein the Court stated the following:
- That the total and absolute prohibition to deduct pro rata expenses abroad under Article 32, Section XVIII of the MITL "may affect the tax equity and proportionality principles"; however, the Court did not declare this article to be unconstitutional.
- Under a systematic and progressive interpretation, the Court concluded that the prohibition to deduct pro rata expenses incurred abroad is not absolute and unrestricted, but the expense in respect of legal services may qualify as deductible if it meets certain requirements, namely the following: i) that the transaction has been carried out in accordance with the transfer pricing rules, ii) maintain the documents supporting the transaction so that the authenticity thereof may be verified, as well as the amounts and strict indispensability of the expense, based on objective accounting and tax criteria and for actual business reasons, iii) that there is a reasonable relationship between the expense disbursed and the benefit obtained, so that this expense may not unjustifiably exceed the benefit.
- The effect of the judgment was granting protection to the claimant in order for the Federal Tax Court to declare the nullity of the resolution determining the tax liability so that it is verified whether the expense incurred by the claimant meets or not all the necessary requirements to deduct this expense and that the respective deduction cannot be disallowed for the simple fact of being a pro rata expense abroad.
Thus, the Court’s new interpretation of this article is interesting since even if the MITL in Article 32, Section XVIII expressly prohibits deducting pro rata expenses incurred abroad with persons that are not taxpayers of income tax under the terms of Titles II and IV of the MITL, the Court, without declaring the unconstitutionality of Article 32, Section XVIII, considered that expenses in respect of legal services incurred by the company that filed the amparo lawsuit (constitutional relief action) could qualify as a deductible expense, taking into account the particular circumstances of the case and following the guidelines expressed in the judgment and that are supported with the requirements for deductions in the MITL.
In this regard, it is important to mention that the effect of the judgment is not declaring that all pro rata expenses incurred abroad with persons that are not taxpayers of income tax in Mexico qualify as deductible items.
Additionally the judgment gave rise to the publication in the Federation Judicial Gazette on June 20th of three isolated judicial criterions which do not constitute binding jurisprudence precedent (jurisprudencia) and therefore are not mandatory for courts its application, moreover, the unconstitutionality of Article 32, Section XVIII, prohibiting to deduct expenses prorated abroad, was not declared.
Likewise, taking into consideration that the MITL expressly prohibits to deduct these types of expenses, the authorities may disallow these deductions, provided that this disallowance is based on proper grounds and reasons.
Nevertheless, we are of the opinion that the judgment of the Court is very useful with respect to the guidelines developed therein in order to better support the deductibility of expenses with residents abroad. In this regard, following these guidelines would be appropriate to review the transactions giving rise to payments abroad in order to confirm whether all of the above-mentioned requirements have been met to duly support the deduction thereof and mitigate a tax contingency in the event there was an inspection by the tax authorities. Likewise, in the specific cases where the deduction of certain expenses incurred abroad has not been taken, according to the applicable legal provisions and considering these guidelines of the Court, the possibility of supporting these expenses may be considered as well as the possibility of applying for a refund of income tax, as applicable.