Mexico: Checks and Balances, a new set of Rules for Taxation in Mexico*

Article by Ricardo Leon-Santacruz**

The last ten years have been maturing years for Mexico and its democracy. We have gone from a state controlled single party presidential system to a true democracy, in which a rebellious Congress seeks to take power away from a traditionally overpowering yet currently naïve Presidency, while both are being frequently subject to the review of a maturing Supreme Court. The recurring battles between the Congress and the Presidency have been cause for last minute budgetary approvals and late night tax bill amendments, which were under the gun of a deadline to avoid utter chaos because of lack of tax reform and budgetary approvals, have left taxpayers will all sorts of unlawful taxes which lack legal or economic basis (for example the Substitute Tax on Credit Salary, a limitation in tax consolidation to 60%, etc.).

This year, for the first time ever, the tax bill was approved by Congress on November 15, its newly appointed approval deadline. The tax bill was approved by consensus between the Presidents right wing party (the "PAN") and the center of the isle former governing party (the "PRI"). Unfortunately the congressional consensus between the two did not last long, and the budget proposal presented by the President was modified by a joint center isle ("PRI") left wing ("PRD") coupe, which reassigned a significant portion of the budgeted expenditures in favor of the State or regions in which such parties have a strong political interest in an early race for the 2006 presidential elections. Upon approval of such budget, the President immediately indicated that he would oppose such budget and invited Congress to review it, however, discussions between congressional leaders and the office of the presidency have broken of and the President has formally opposed publication of the budget and has returned it to Congress with a request for a formal revision. Although historically this occurred before, it is the first time it has taken place in the context of a power struggle between the executive and legislative branches of government. We hope consensus between both powers is reached prior to the year end, as none had been reached at the time this article was submitted for publication. However, it is likely that it will be up to the Supreme Court to resolve yet another issue between the feuding parties.

With the thought of our prior years last minute tax bills and the Supreme Court’s involvement as the only party who has ensured that Congress abides to the Constitutional Principles of legality, equity and proportionality as governing principles of all tax laws which are put in place in Mexico, we herein will highlight five major examples in which the Mexican Supreme Court ruled on these items and the implications of such rulings in our legislative process.

Under Mexico’s Assets Tax basis, i.e. the alternative-minimum-like tax levied at a 1.8% rate on the value of the assets, debt hired with Mexican financial system entities or with non-resident beneficiaries, is non-deductible. When analyzing the issue with respect to the financial system, the Mexican Supreme Court issued binding jurisprudence (which is created by the issuance of five consecutive rulings in the same sense), through which it ruled on the unconstitutionality of the asset tax base deduction limitation, indicating that the failure to consider the debt held with the financial system (or with non-residents as ruled in other cases) created a false tax base, violating the equity principle sanctioned by the Federal Constitution . Although binding on Federal District Courts and the Tax Courts, the benefits of jurisprudence can only be accessed by interested parties through rulings in which a court confirms that the jurisprudence applies to the case presented and hence, benefiting from such precedent does must be sought individually by each taxpayer. As explained further below, this ruling by the Supreme Court has served as basis for an amendment to the Asset Tax Law, which as of 2005 will allow the deduction of the debt held with members of Mexico’s financial system or with non-residents, as deductible items for purposes of determining the asset tax basis.

VAT is a tax that works based on the offset of the tax paid to suppliers against that which is charged to consumer, with the balance being payable to the government. However, there are certain activities which are exempt from VAT, and thus make the credit of the taxes paid impossible. To determine the amount of the creditable taxes when a taxpayer is involved in the rendering of services or sales of goods to third parties which can be both taxed and exempt, the VAT law establishes a crediting ratio which is determined based on the immediately proceeding years ratio of taxed and exempt activities. Because the elements which conform the basis of the tax, mainly the exempt-taxed ratio of the prior year, the Supreme Court ruled such crediting ratio to be unconstitutional on the basis of the proportionality principle due to the fact that such ration cannot adequately reflect the taxpayer capability to pay the tax at a given month. This resolution is easier to illustrate through an example. Assume that a taxpayer in the immediately proceeding year sold houses and industrial buildings in the same, because houses are exempt, in the prior year he generated a ratio of 50%. If in the following year the taxpayer decides to focus solely on the sale of industrial buildings, he will only be able to credit 50% of the VAT because of the ratio, although is no longer involved in an exempt activity, hence the lack of proportion on the basis of the credit. As a result of this ruling, an amendment to the VAT law credit system was introduced through the Senate. Unfortunately, many of the issues dealt with by the Supreme Court, were reintroduced on the newly enacted credit system.

Employee profit sharing is a mandatory obligation pursuant to Article 123 of the Federal Constitution. The applicable distributions rate is 10%. Moreover, the Constitution calls for a basis of distribution of based on taxpayers pre-tax earnings. Regardless, the Mexican Income Tax Law calls for a special basis which is different from the pre-tax earnings as the basis for employee profit sharing distributions. This special basis was ruled unconstitutional by the Mexican Supreme Court, allowing for a reduced profit sharing basis which represents important savings for employers. Unfortunately, the Court also ruled that employee profit sharing is not a deductible expense.

Fortunately, the amendments to the Income Tax Law applicable as of 2005, call for the deductibility of the employee profit sharing payments for the 2005 profits paid out in 2006 and on a going forward basis. Hence, employers are encouraged to apply the reduced employee profit sharing basis as ruled by the Supreme Court and take advantage of the deduction of paid out employee profit sharing, in order to maximize the benefits savings and benefit of the amendments to the law.

The Mexican Income Tax Law establishes a limitation on the use of Net Operating Losses which originate from the disposition of stock, allowing the use of said NOL to apply only against capital gain income. In this respect, the Supreme Court has established jurisprudence declaring such limitation unconstitutional. Hence, NOLs originating from the disposition of stock or capital interest can be offset against ordinary income. This finding is extremely relevant as it establishes the willingness of the Court to rule on issues of law based solely on the merits of the case. No amendment proposal which would seek to "go around" the Courts finding was introduced, thus taxpayers can feel at ease about using their capital losses to offset their ordinary taxable gain.

Probably the most noteworthy Court finding pertains to a matter of procedure. The Supreme Court’s ruling in this respects opens the door for taxpayers to seek the benefits of jurisprudence issued by the Supreme Court, even if a taxpayers has initially failed to seek Constitutional injunction relief within the terms set forth in the Amparo Law, which obligates taxpayers to seek judicial relief upon the first of either the enactment of a law or the first act of application of the law, whether self applied or enforced by an act of authority. Hence, taxpayers who might have not sought a challenge of a given issue of law which affects them, if said issue is ruled unconstitutional and jurisprudence is formed, the taxpayer might seek recourse through rulings or amended returns claiming the benefits of such jurisprudence, with the judicial authorities who review the case being obligated to apply the benefits of the jurisprudence to the taxpayer.

As indicated in the recap of the Court’s ruling regarding the Asset Tax allowing the deduction of debt held with entities which are part of the Mexican financial system and with non-residents, the Asset Tax Law was amended to include both the debts held with non-residents as well as those kept with entities which form a part of the Mexican financial system, a benefit which can greatly reduce the asset tax basis to which the 1.8% rate applies.

The amendments to the corporate income tax law are very significant. Initially, we can point out a reduction of the corporate income tax rate, from the scheduled rate of 32% for 2005 to a 30% rate for 2005. This rate is further reduced to 29% for 2006 and 28% for 2007 and thereafter. However, if we compound the benefit of the employee profit sharing deduction, the effective tax rates will be 30% for 2005, 26.1% for 2006 and 25.2% for 2007 and thereafter, a welcomed amendment which might cause many taxpayers to rethink their Mexican subsidiary’s "pass-through" treatment to take advantage of the benefits of deferral.

Regarding the employee profit sharing deduction, it is worth noting that such deduction applies in a way similar to that of the amortization of NOLs and, therefore, it does not affect the determination of the employee profit sharing itself. Compliance requirements for deductions continue to be introduced in the MITL. Two examples of which are a requirement for payment through check, credit or debit card or electronic cash, in order to expense fuel for vehicles and the requirement of registering employees in the Mexican Social Security Institute in order to deduct salaries paid to employees.

Green energy production equipment or investments will be deductible at a 100% rate, conditioned only on the operation of such investment for a period of not less than 5 years. Improvements and investments which benefit the handicapped individuals will also be fully deductible in the year in which the investment is made.

Although the entire world deducts its investments on a cost of goods sold basis, since 1986 Mexico allowed for a deduction of inventories on a basis of the acquisition of the inventory. Effective January 2005, Mexico’s reincorporates its investment deduction basis following the global principle of cost of goods sold. Unfortunately, the transition to a cost of goods sold basis will significantly implicate taxpayer’s financials. To alleviate the implications of such transition, a 4 to 12 year transition period is introduced.

An important tax event in 2004 was the publication in the Tax Administration Service web page of certain structures or activities which were considered to be abusive structures in the eyes of the tax authorities. Said publication was nothing more than a threat by the authorities, as it lacked any legal basis for such publication and no action could have been initiated by the authorities based on such publication. However, this publication forewarned us about some of the items the authorities would seek to introduce as amendments to the tax laws. Among these proposals was the introduction of thin capitalization provisions, which have been enacted into the law and will become applicable as of January 2005. The debt to equity ratio introduced into the law is a 3 to 1, debt to equity ratio. For taxpayers who might exceed the ratio, a five year phase out period was introduced, subject to certain restrictions. Also, for major projects, the possibility of exceeding the 3 to 1 ratio, a Advanced Pricing Agreement procedure has been introduced. Unfortunately, the backlog on APA’s is so extensive, that it is very troubling to see that an APA will be required on major projects in order to avoid thin cap limitations.

A welcomed amendment for 2005 is the repeal of the 60% limitation for tax consolidation. Effective January 2005, tax consolidation in Mexico returns to 100%, making such regime an attractive alternative that "must" be reviewed by investors with significant operations in Mexico.

A number of items are introduced as Mexican source taxable income generating items of income. The first of these is the introduction of stock-option benefits as taxable salary for non-resident with Mexican sourced salary income. A rebuttable presumption of Mexican source income is introduced for professional services paid to related parties of Mexican resident entities or permanent establishments of foreign entities. The sale of stock of a non-resident entity whose assets are comprised 50% or more by Mexican real estate have always been considered to be subject to tax in Mexico, as a Mexican source income. This provision has been amended to include indirect land ownership structures which ultimately are conformed by Mexican real estate, as items which are deemed to be of Mexican sourced taxable income.

A newly enacted source of income scenario was introduced on sales of stock. This amendment establishes that if economic interest over stock is transferred, without having an actual sale of the stock ownership interest, the transfer of the economic will be deemed to be a disposition of the stock subject to capital gain. Another item for which a newly enacted source of income item was introduced as it refers to interest. This newly enacted scenario addresses the case in which a non-resident beneficiary of a debt receivable owed by a Mexican resident to a non-resident sells such receivable to a resident in Mexico, in which case the difference between the debt principal and the excess is deemed to be interest subject to withholding tax in Mexico, at the rate which apply based on the beneficiary of the interest (i.e. bank, insurance company, etc.).

A very troubling amendment for withholding agents on payments to non-residents goes in hand with the extension of the preferential tax regime anti-abuse provision which is being extended to a full controlled foreign company ("CFC") legislation as explained further below. The concern stems from that all of the withholding rates applicable to payments to non-residents if the beneficiary thereof is a CFC or is located in a "black-listed" jurisdiction, the applicable withholding rate is increased to a 40% withholding rate, a very burdensome obligation which will surely raise eyebrows on withholding agents. This withholding obligation will surely trigger some treaty overriding discussion between withholding agents and beneficiaries of payments, as withholding agents will be likely to want to avoid joint liability exposure and thus, withhold the 40% rate unless, of course, the recipient of the payments delivers certificates of residence which evidence their entitlement to claim treaty benefits, if applicable.

The most concerning, troubling and disturbing amendment of the entire tax reform, in the authors view, is the amendment to the definition of "business activities", set forth in the non-resident taxpayers chapter of the Income Tax Law. This provision was amended to exclude almost all of the scenarios of Mexican source income attributable to non-resident from the definition of "business activities." In and of itself, this amendment is unclear and its consequences are uncertain. However, if we analyze this amendment in light of Mexico’s tax treaties, a disturbing conclusion is reached. The amendment to the "business activities" definition appears to be intended to support an argument under an interpretation of a tax treaty that would nullify the "business profits" principle for exemption of tax in the source country. In its place, the authorities could make a claim that when an entity claims it is not subject to tax in Mexico, because business profits are not defined in the treaty, they could under the undefined terms provisions of Article 3 of the treaty, resort to internal legislation to define said term. There under, because the term would have a negative definition, the authorities could claim a right to tax under the "other income" provision of the treaty and hence, tax at source under the provisions of the law. We hope that this analysis and interpretation of the amendments is not true, as it would represent a very disturbing position from the tax authorities which, until this amendment, had only toyed with some treaty overriding provisions, but could be said to have been respectful of the importance of tax treaties within Mexico’s tax policy and investment certainty producing legislation.

Under the existing Jurisprudence issued by the Supreme Court, in Mexico the Court has ruled that international treaties clearly prevail in the event of a conflict with the internal legislation. With such binding precedent on file, clearly the outcome if and when a case is brought against a taxpayer with the reasoning described above, will be ruled in favor of the taxpayer. However, the fact that taxpayers need to challenge and defeat the authorities does not provide the legal certainty that a capital importing country must offer to attract foreign investment. Fortunately, under our new found check and balances system, we are trustworthy that as in the cases described above, the Mexican Supreme Court will find in favor of the merits of the principles sanctioned by the Federal Constitution to which tax laws must abide.

The amendment which will become effective January 2005 includes the enactment of a comprehensive Controlled Foreign Corporation or CFC legislation. This legislation combines the continuance of the existing black-listed territory regime with a minimum income tax threshold requirement for non-black listed country investment vehicles.

CFC’s are defined as entities subject to a preferential tax regime. Preferential tax regimes exist when the taxpayer which is subject to tax outside of Mexico is taxed at a rate which is less than 75% of the income tax applicable in Mexico. Hence, considering the new corporate income tax rates, the threshold are 22.5% in 2005, 21.75% in 2006 and 21% in 2007 and thereafter. Indirect investments must also be computed taking into account any and all vehicles through which investments were made. If these thresholds are met, the Mexican taxpayer who holds an investment through such vehicles, will be obligated to an advanced recognition of income regardless of the place through which such investment is performed.

Notwithstanding, an exclusion to an advance income recognition obligation if income arises from an active trade or business and if at least 50%of the total assets of these investments consist of fixed assets, real estate and inventory which is used in the performance of such active trade or business. Also, if income which is not passive income is obtained by a vehicle located in a country with which Mexico has a broad exchange of information agreement, the income will also not be subject to the advanced income recognition obligation. Passive income is defined as interest, dividends, royalties, capital gain from the sale of stock, securities or real estate, lease income and in kind income received for free as part of the performance of a business activity.

Exceptions from the foregoing income recognition obligation exist for indirect investments through investment vehicles located in jurisdictions in which advanced income recognition is mandatory by statute and the investor can evidence that such investment vehicle did in fact recognize such income. Also excluded from such advanced income recognition obligation are those indirect investments in which the average daily interest of the investor does not allow such investor to hold effective control over the time in which the income is to be distributed to the investor, whether directly or indirectly. Control is determined based on direct daily average participation and that held by related parties. Absent control on direct investments or in indirect investments, the investor may be entitled to defer the income recognition until profits are actually distributed. Hence, some planning opportunities remain available for Mexican residents.

An additional new concept was also introduced along with the enactment of the CFC legislation. This concept is that of fiscally transparent entities, or entities in which income flows through directly to partners, without having a tax apply to the vehicle itself. This is a revolutionary concept in Mexico, as it will implicate an advanced recognition of income as a result of the flow through treatment of the vehicle, a concept which has for many years been in place in other jurisdictions. Unfortunately, the rules as to transparent entities are very limited, and one must only hope that additional legislation in this respect is published in order to determine if such transparency will also be considered for purpose of crediting indirect taxes, credit which is limited to two tiers of subsidiaries under current law, but which could also be affected by the transparency rules extending such credit to additional levels of subsidiaries.

* An edited version of this article was recently published by Tax Analysts in "Tax Notes International"

** Ricardo Leon-Santacruz is a Partner of the Tax Practice Group of Sanchez-DeVanny Eseverri in its Monterrey, Mexico office. The author extends special thanks to Jose Angel Eseverri, Jose Luis Duarte, and Hernan Gonzalez for their valuable insights in the preparation of this article.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.