On December 9, 2019, the Decree that amends, modifies and repeals provisions of the Income Tax Law, the Value Added Tax Law, the Excise Tax Law and the Federal Tax Code was published in the Federal Official Gazette.
The amendments published and generally enforceable as of January 1, 2020, have as their main objective to incorporate into Mexican tax law the recommendations issued by the Organization for Economic Cooperation and Development (OECD) in the BEPS Project, with the purpose of tackling tax avoidance and evasion at an international level.
In addition, the tax reform seeks to establish a new regulatory framework to reinforce the ability of the tax authority to prevent tax evasion that results from aggressive tax planning, use of fraudulent invoices and outsourcing. Finally, the reform sets forth a new tax regime applicable to the digital economy in Mexico, by including measures to tax those who perform activities in Mexico through technological platforms and digital applications, particularly those who operate from abroad. The most important amendments of this Tax Bill are described below.
BEPS: Base Erosion and Profit Shifting
CFDI: Digital Invoices
Comments: OECD Commentaries on the 2017 Model Tax Convention
FLL: Federal Labor Law
FTC: Federal Tax Code
ITL: Mexican Income Tax Law
MLI: Multilateral Convention to Implement Tax Treaty Related Measures to Prevent
BEPS Model: 2017 OECD Model Tax Convention on Income and on Capital
OECD: Organization for Economic Co-operation and Development
PE: Permanent Establishment
REFIPRES: Preferential Tax Regimes
RFC: Federal Taxpayers Registry
SAT: Tax Administration Service
SHCP: Ministry of Finance and Public Credit
VAT: Value Added Tax
VATL: Value Added Tax Law
Income Tax Law
Permanent Establishment Following the recommendations of Action 7 of BEPS, which were adopted by Mexico as signatory to the MLI, the definition of PE is updated to include additional cases in which a foreign resident will be deemed to have a PE in Mexico, as well as to limit the applicable exceptions to such cases.
Agency PE: Dependent Agent
The ITL already established that foreign residents would constitute a PE in Mexico when they act in the country through a dependent agent that concludes contracts in their name or on their behalf.
However, it is now also established that a dependent agent will trigger a PE in Mexico for the foreign resident if such agent concludes contracts, or habitually performs the main role that leads to the conclusion of contracts by the foreign resident, and they:
- are entered into in the name or on behalf of the foreign resident;
- relate to the transfer of ownership of, or grant the temporary use of property owned or temporarily under the use and control of the foreign resident; or
- bind the foreign resident to perform a service.
Before the tax reform, in order for a foreign resident to trigger a PE in Mexico it was required that the dependent agent through which it was acting had the legal ability to execute contracts in its name or on its behalf. However, it will now be sufficient that the dependent agent concludes or habitually performs the main role leading to the conclusion of such contracts, which does not necessarily require that such agent holds a power of attorney from the foreign resident.
The purpose of this amendment is to tackle tax schemes through which a dependent agent habitually negotiated contracts that benefited a foreign resident but such activity did not amount to a PE by itself because the dependent agent did not conclude or execute such contracts though a power of attorney formally granted by the foreign resident.
Important new terms are included in the ITL, such as the "conclusion of contracts" and "performing a main role" that leads to the conclusion of contracts in an "habitual" manner.
The scope of such terms is analyzed in the Commentaries, which already incorporate the recommendations of Action 7 of BEPS. However, the ITL reform does not establish the specific scope of such concepts, which suggests that the Commentaries could be relevant to interpret them. How these concepts are interpreted by authorities and courts will have relevant tax implications.
Agency PE: Independent Agent
The current ITL establishes how a foreign resident triggers a PE in Mexico by acting through an independent agent, i.e. when such agent does not act within the scope of its ordinary activities. However, before the tax reform, no specific parameters were in place to determine whether an agent was, in fact, independent.
Hereinafter, an agent will not be deemed to be independent when it acts "exclusively" or "almost exclusively" on behalf of a foreign resident who is its related party. This amendment seeks to combat tax schemes where taxpayers argued that an agent, through which they acted in another jurisdiction, is an independent agent without actually being so.
The scope of the terms acting "exclusively" or "almost exclusively" on behalf of a foreign resident, is also analyzed in the Commentaries. The Commentaries establish as a general parameter that, in order to conclude that an agent does not act "exclusively" or "almost exclusively" on behalf of a foreign resident, at least 10% of the sales conducted by such agent should be carried out for companies that are not "closely related".
Notwithstanding the above, the ITL reform did not incorporate such parameter, which again suggests that the Commentaries could become relevant to determine the scope of such concepts. Finally, unlike Action 7 of BEPS, where reference is made to acting "exclusively" or "almost exclusively" on behalf of one or more foreign residents who are "closely related" to the agent, the amended ITL replaces the "closely related" concept with a "related parties" concept. Such term was already defined in the ITL and results in a broader concept than that of "closely related" as defined in the Model.
Activities of a preparatory or auxiliary nature
The ITL already established a list of activities that constituted exceptions to the creation of a PE in Mexico by foreign residents, under the automatic assumption that these activities were of a preparatory or auxiliary nature.
However, such exceptions will no longer apply automatically, as the amended ITL sets forth that they will only be applicable when the activities conducted are truly of a preparatory or auxiliary nature.
Before the tax reform, the ITL did not provide an antifragmentation provision applicable to the exceptions of the creation of a PE in Mexico by foreign residents.
A new anti-fragmentation rule states that the exceptions established for preparatory and auxiliary activities in the amended ITL to the creation of a PE in Mexico will not be applicable if the foreign resident conducts activities in one or more places in Mexican territory, which activities form part of a comprehensive business operation of an already existing PE of such foreign resident or of a related party to such foreign resident. Similarly, these exceptions will also not be applicable if the foreign resident or a related party has a place of business in Mexico where activities that are ancillary to a comprehensive business operation are carried on and such activities are not , considered as a whole, of a preparatory or auxiliary nature.
The foregoing is aimed to address PE avoidance by foreign residents, either on their own or in conjunction with related parties, through the fragmentation of activities which, on their own, could be characterized as having a preparatory or auxiliary nature, but when considered as whole no longer are of such preparatory or auxiliary nature and consequently would amount to a PE.
In this case, the tax reform also refers to the term "related parties", which is already established in the ITL and has a broader reach than the concept of "closely related" used in Action 7 of BEPS and defined in the Model.
The ITL reform seeks to tackle PE avoidance abuses by foreign residents. The inclusion of this amendment was also necessary to secure the validity of (i) amendments made to Mexico´s Tax Treaties , including those provisions adopted to broaden the cases where a PE would exist in Mexico, and (ii) the ratification of the MLI by Mexico.
Notably, in the MLI context, since there is no minimum standard for its adoption and not all signatories have adopted the totality of the recommendations of BEPS Action 7 relating to new PE cases, failure to enact domestic legislation could have left areas of opportunity for foreign residents to apply treaty benefits with the objective of avoiding triggering a PE in Mexico.
Income derived by transparent foreign entities and foreign legal vehicles
Foreign transparent (pass through) entities and foreign legal figures receiving Mexican source income must now in certain scenarios determine their own tax result, as taxpaying corporate entities separate from their members, partners, shareholder or beneficiaries, and be subject to income tax in Mexico according to the rules set forth in the ITL. This is true even if such income is considered as taxable income of their members, partners, shareholders or beneficiaries in the country of residence of such entities and legal figures.
In addition, foreign pass through entities and foreign legal figures shall be considered Mexico tax residents when the location of the principal administration of their business or the headquarters of their effective management, is in Mexico.
Determining whether a foreign vehicle has legal personality will continue to be critical to determine its tax treatment. The Tax Reform sets forth the following classifications:
- Foreign entities: legal entities incorporated according to Mexican law that are foreign residents, as well as legal entities incorporated according to foreign law, provided that they have a legal personality.
- Foreign legal figures: trusts, associations, investment funds and any other legal agreement or vehicle incorporated under foreign law that does not have legal personality.
In addition, foreign entities and legal figures shall be considered pass-through for tax purposes provided that the two following requirements are met:
- they are not tax residents for income tax purposes neither in the country or jurisdiction where they have been incorporated nor in the country or jurisdiction where they have established the principal administration of their business or of their effective management; and
- their income is automatically attributable to their partners, members, shareholders or beneficiaries.
Finally, the ITL recognizes the hierarchy of tax treaties over Mexican federal legal provisions and confirms the Mexican tax policy of non-recognition of pass-through entities or vehicles, except for certain cases where Mexico has negotiated specific positions in bilateral agreements with other countries.
Tax Incentive for Privately Placed Investment Funds
The abovementioned amendments directly affect foreign investment funds that invest in Mexico through foreign tax transparent (pass through) vehicles1 and that typically were exempted of Mexican income tax on specific items of Mexican source income. In the absence of a special tax incentive described below, under this new provision such investment funds would be treated as opaque foreign vehicles2 potentially subject to Mexican tax withholding.
On this note, it is worth mentioning that the Tax Reform was justified based on the need to simplify and control income tax payment in Mexico by concentrating tax payment obligations on one party, that is, focusing on the entity or vehicle receiving the income and not on each of its members that were the beneficial owners of such income. However, the initial proposal of reform did not take into consideration that the outright implementation of such rules could result in serious adverse consequences for investors that use transparent foreign vehicles to invest and operate in Mexico.
For this reason, the initial proposal was supplemented to provide a tax incentive for pass-through foreign legal figures that manage private equity investments in Mexico through Mexican domestic entities. Pursuant to this incentive, under the approved reform, the partners and investors of such legal figures will be taxed directly according to their respective tax regime, provided that the income derived through such legal figures consists of interest, dividends, capital gains or real estate leasing income.
In order to apply the abovementioned tax incentive, the interested party must comply with the following requirements:
- each year file a registry of all partners or members investing in the fund, providing documentation to reflect their tax residency; 3
- the vehicle must be incorporated in a country or jurisdiction with a 'broad exchange of information' agreement in force with Mexico;
- members and managers of the vehicle must be tax residents of a country or jurisdiction with a broad exchange of information agreement in force with Mexico;
- members and managers of the investment fund must be the beneficial owners of income derived through such fund;
- when income is attributed to members of the fund who are foreign tax residents, such members must accrue the income in their country of residence;4
- when income is attributed to members who are Mexico tax residents or foreign residents with a Mexico PE, such members must accrue their allocable income in Mexico in the year in which the income is accrued.5
If the above-mentioned requirements are not complied with, the investment fund will not be considered pass through in the proportion in which such requirements are not met, and will be treated as partially or fully non-transparent.
Since the amendment regarding the new rules for foreign entities and legal figures with Mexican source income will enter into force on January 1, 2021, investment funds will have a year to implement the necessary measures to comply with the abovementioned requirements and be able to apply this tax incentive. Thus, filing of the yearly registry of its members' obligation for fiscal year 2021 shall be complied with as from February 2022.
While the amendment results in new administrative burdens that could represent additional costs for investment funds, having the ITL recognize them as pass-through vehicles through the aforementioned incentive leaves investment funds in a better position than the original bill proposal, which would have resulted in a more adverse economic impact for such investors.
In particular, if the initial proposal had been approved without the abovementioned incentive, the increased tax burden for certain investors such as: (i) pension and retirement investment funds that are exempted from income tax in Mexico, (ii) multilateral organizations exempted from income tax that invest in private equity funds and (iii) those who would have been unable to take a foreign tax credit for the income tax paid in Mexico; would have resulted in a significant decrease of investments in Mexico by such investors, which in turn would have been very detrimental to the Mexican economy.
Finally, it is worth noting that new compliance obligations imposed on investment funds will result in the SAT having the investors' information, which could be exchanged with other countries to enforce due compliance with tax obligations.
Income derived by Mexico tax residents through foreign transparent entities and foreign legal figures
Prior to the Tax Reform, income derived by Mexico tax residents through foreign entities or legal figures was regulated under the REFIPRES regime and its corresponding regulations.
The new tax law will now differentiate between income derived through foreign pass-through entities and legal figures and income obtained through foreign non-transparent entities. Only income derived through foreign non-transparent entities will remain being subject to the REFIPRES regime.
Consequently, under the amended ITL, Mexico tax residents who derive income through foreign passthrough entities and foreign legal figures, will not be subject to the REFIPRES regime but, on the contrary, shall directly recognize such income under the rules of the newly enacted Article 4-B.
Article 4-B now limits the ability of Mexican tax residents to defer payment of income tax on the income derived through foreign pass-through entities and legal figures by taking the position that one of the REFIPRES regime exceptions, particularly the 'lack of control' exception pursuant to which said taxpayer did not have control over the timing and manner of the distributions of dividends or profits obtained by the foreign pass-through entities or foreign legal figure, applied to them. As such, under the new provisions, income derived from foreign pass-through entities or foreign legal figures will be automatically and immediately considered taxable income, regardless of whether such entities or legal figures make distributions or whether their members, partners, shareholders or beneficiaries have control over such distributions.
Income accrual by Mexico tax residents for income derived through foreign pass-through entities or foreign vehicles, as well as for the payment of the corresponding income tax, will depend on the type of vehicle through which income was derived, as follows:
- Pass-through entities: income will be accrued and taxed on tax profit for the calendar year, according to the rules set forth for Mexican legal entities.
- Pass-through legal figures: income will be accrued in terms of the tax regime applicable to the taxpayer that has a participation in such vehicle and will be taxable in the calendar year in which the income is accrued, taking into account the tax deductions applicable for such legal figures.
- Non-transparent6 legal figures: income will be accrued and taxed on the tax profit for the calendar year, according to the rules set forth for Mexican legal entities.
Income derived from foreign pass-through entities or pass-through vehicles shall be added to the other taxable income of the involved Mexico tax residents, according to their applicable tax regime, that is, as an entity or individual. The tax treatment provided by this amendment significantly differs with the REFIPRE regime that was previously applicable to income derived from such foreign entities and legal figures.
Taxes effectively paid in Mexico or abroad by the entity or legal figure can be credited against the income tax due by the underlying Mexican taxpayer.
New rules do not expressly provide for the calculation of the corresponding taxable profit in the foreign functional currency of the corresponding entity or legal figure, which could result in having to recognize foreign currency exchange gains or losses derived from foreign currency fluctuations, even if the taxpayer has a participation in a foreign entity or a non-transparent legal figure. Finally, the new provisions still require the taxpayer to (i) keep a Net After-Tax Profits Account (CUFIN per its Spanish acronym) for each of the entities or legal figures in which they participate, as per the guidelines of the REFIPRE regime, for purposes of recording the amount of income that has already been taxed and that can be later distributed by the foreign entities and legal figures without triggering an additional tax, and (ii) to file the corresponding informative tax return.
Coordination with Controlled Foreign Entities Regime subject to REFIPRES
The abovementioned rules shall be applicable if a Mexico tax resident holds a direct participation in the foreign pass-through entity or foreign legal figure, or holds an indirect participation that exclusively involves other foreign pass-through legal entities or foreign legal figures. However, if the indirect participation of the Mexico tax resident involves at least one nontransparent foreign entity, the REFIPRES regime rules will apply instead for income derived through such entity.
1 Prior law set forth that, for foreign investment funds that operated through pass-through foreign legal figures, the investors thereof were directly taxed on income generated through such funds and as such would pay income tax according to their applicable particular tax regime. As such, investors who had beneficial tax treatment could invest through such legal figures and still enjoy such beneficial treatment (for example, pension and retirement funds are exempt from income tax in Mexico).
2 In other words, tax treatment of an investment fund set up as a foreign legal figure would be the same as that of a foreign entity, i.e. it would be subject to tax as a separate taxpayer.
3 If a member is an international organism (such as the International Monetary Fund) or a pension and retirement fund, the international organization formation deed can be provided instead.
4 Income exempted from income tax must also be accrued; however, such mechanism should not result in exempt income being considered taxable income.
5 The ITL sets forth that members who are Mexican tax residents or foreign residents with a Mexico PE shall accrue such income according to the new rules set forth for foreign entities and vehicles, or according to the REFIPRE regime.
6 Vehicles that are considered as taxpayers on their own in the country in which they were incorporated or formed.
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