Mexico is one of the few countries with a special exemption regime for foreign pension funds investing in the country. This exemption was incorporated into the tax system as a general withholding exemption for such funds when obtaining any type of Mexican source income through a presidential decree published on March 25 1992, and then into the Income Tax Law in July of that year. Raul Morales Medrano of Chevez, Ruiz, Zamarripa y Cía, outlines the latest changes impacting pension funds in Mexico.
In 1995, the possibility for such pension funds to invest in Mexico through foreign persons or investment funds to maintain the exemption was incorporated through administrative rules, as it was necessary for the regime to properly function considering that, in certain cases, regulatory restrictions limited funds to invest directly in Mexico. These intermediate vehicles needed to be registered in a special registry created for such purpose.
That was until 1998, when the exemption was limited to certain types of income. That year, the law established that only interest and capital gains earned by such pension funds would be exempt if the funds were registered in Mexico and some other requirements were met, including, for example, that such income was also exempt in the country of residence of the pension fund, and that such country established reciprocity for Mexican pension funds (this last requirement was quickly eliminated, for year 1999).
Leasing income from real estate was eliminated from the exemption, which apparently was not intentional, since this situation was corrected on February 14 1998 through an administrative rule that, for the first time, incorporated special requirements that had to be met in order for the withholding exemption for rental income to apply. Such requirements included that the rental income should not be linked or conditioned to the income of the lessees, and that capital gains would be understood as the sale of shares (in general) and of real estate assets located in Mexico, to the extent the real estate assets had been leased for a minimum period of one year preceding the sale.
Starting in 1999, the withholding exemption regime for foreign pension funds that has been described was incorporated into the law, and remained as such, substantially, until December 2013. Article 144 of the 1999 law provided that (i) interest income, (ii) rental income and (iii) certain capital gains earned by foreign pension funds from Mexican source, would be exempt in Mexico if certain requirements were met, such as the pension funds being registered in Mexico, a lock-up rental period of one year would be required for the sale of real estate property to qualify as an exempt capital gain, and the rental income could not be determined based on the income of the lessee. The definition of capital gains was narrowed to only include shares of real estate companies as defined by the law. This withholding exemption provided by the law will be referred to as the 'primary exemption'.
Article 144 incorporated a ninth paragraph with a second exemption for investments made by foreign pension funds in Mexico through Mexican resident entities (the 'secondary exemption'). The exemption would apply for Mexican resident entities that were owned by foreign pension funds to the extent that at least 90% of their total income derived exclusively from qualifying income (rental income or capital gains deriving from the sale of shares issued by real estate companies, defined as entities derived in more than 50% from real estate located in Mexico).
For January 2002, a new Income Tax Law (ITL) was issued which continued to include both the primary and the secondary exemption as previously described.
New administrative rules were published on May 30 on the possibility to apply the secondary exemption to foreign vehicles owned by pension funds and invested in Mexico. This rule was then passed in October 2013 as article 248 of the Regulations to the new ITL.
Based on the wording of article 248 of the Regulations, both the primary and secondary exemptions applied regardless of the tiers the foreign structure had used to invest in Mexico, to the extent the foreign vehicle earning Mexican source income (for purposes of the primary exemption) or investing in the Mexican entity (for the secondary exemption) was investing funds contributed by foreign pension funds, and this was evidenced when requesting for the registration of the intermediate vehicles in Mexico.
These two exemptions continued to clearly apply until December 2013, when the 2002 ITL was repealed. Although both the primary and secondary exemptions were renewed by article 153 of the new law, two slight modifications were made: (i) the registration of the funds or intermediate vehicles in Mexico was no longer necessary; and (ii) the lock-up rental period for capital gains was increased from one year to four years. Due to the elimination of the registry, it became uncertain if both exemptions continued to be valid when investing in Mexico through foreign vehicles, as such possibility derived from article 248 of the Regulations which conditioned such exemptions to the registration of the intermediate vehicles, despite some references in the administrative rules published by the tax authorities for years 2014 and 2015, which suggested that article 248 of the regulations continued to be applicable.
It is important to note that a transitory provision of the new ITL established that all regulations to the law would continue to apply in 2014 and subsequent years until new regulations were published, to the extent that the provisions of such regulations were not contrary to those of the 2014 law. Therefore, one would need to interpret that the registration requirement for intermediate foreign vehicles should be just ignored, as its existence or inexistence did not imply a change in substance of the exemption regulated by article 179 of the 2002 law (now article 153), in order for both exemptions to continue to apply.
The 2014 Bill incorporated a new dividend tax of 10%, when dividends were paid by Mexican entities to non-residents in general (and also to Mexican individuals), and no exception was included for pension funds investing in Mexican entities in Mexico. Therefore, the investment of pension funds passed from being fully exempt to being taxed with a 10% levy on the dividends received (when these derived from profits generated starting January 2014).
So, at that point in time, there were various problems for pension funds that had invested huge amounts of resources in Mexico relying on the exemption offered by the Mexican government in previous years, including:
- Dividends tax – dividends to be received by foreign pension funds from Mexican entities should not be subject to the 10% tax where the paying entity qualified for the secondary exemption;
- Indirect structures to hold investments in Mexico should be respected (for both the primary exemption and the secondary exemption) and the uncertainty of whether article 248 of the old regulations continues to be valid should be clarified.
This first problem was solved on October 16 2014, through the incorporation of a rule within the Miscellaneous Tax Resolution for 2014 (renewed for 2015 and incorporated into the regulations for 2016), which established that the 10% withholding would not apply when Mexican resident entities paid dividends to foreign pension funds (directly) deriving from article 153 exempt income, to the extent such Mexican entities were exempt under the secondary exemption rules, and: (i) dividends or profits derived from exempt income at the level of the Mexican entity (to be evidenced by the entity); (ii) the foreign pension funds were the beneficial owners of such dividends; (iii) dividends were exempt in the country of residence of the foreign pension fund; and (iv) the foreign pension funds resided in a country with which Mexico has in effect a broad agreement for the exchange of information.
Note that these rules only provided relief when dividends were paid directly to the pension funds, meaning that the original problem remained for multi-tier foreign structures, which also suggested that article 248 of the regulations to the law may have not been in effect as, otherwise, such new rule would have also considered dividends paid to foreign entities held by pension funds. This problem was subsequently solved with additional rules analysed later in this article.
On October 8 2015, the new Regulations to the 2014 ITL were published, coming into effect a day later. Article 272 of said regulations was designed to substitute article 248 of the old regulations. However, as drafted, although it serves as an extension to the exemption regime provided by article 153 of the law, it only extends the application of the primary exemption (that is, withholding relief for Mexican source income), and does not include any reference to the secondary exemption at all.
Article 272 establishes that the primary exemption would be extended to investments made in Mexico by pension funds through one foreign entity or fund (one-tier structure to hold real estate properties located in Mexico), and that such exemption would only apply to: (i) qualifying rental income; and (ii) qualifying capital gains (leaving out interest income).
This new regulation also established some requirements that would be necessary for the primary exemption to apply to the foreign vehicles owned by pension funds, namely that: (i) at least 90% of the income of the foreign vehicle derived from rental income or qualifying capital gains; (ii) income earned by the foreign vehicle is income tax exempt in the country of residence of such vehicle, and also exempt when received by the pension fund; (iii) the foreign vehicle resides in a country that has a treaty for the broad exchange of information with Mexico; and (iv) all requirements provided by article 153 of the law, and any other administrative rule that may be published by the tax authorities, were complied with.
The main differences between article 272 and article 248 of the old regulations, when dealing with pension funds, may be summarised as follows: (i) multi-tier structures would no longer be allowed to benefit from either the primary or secondary exemptions; (ii) interest income would no longer be exempt; and (iii) some structures (even one-tier) would no longer qualify for the exemption due to the new requirements (that is, foreign vehicles created to invest in Mexico and other countries, which would not comply with the 90% income test as they would obtain income from sources other than Mexico).
In November 2015, a new administrative rule (rule 3.18.3) was published by the tax authorities, allowing the secondary exemption to be applied by Mexican entities owned by foreign investment vehicles that were in turn owned by pension funds (again only allowing a one-tier structure outside of Mexico). However, new requirements would need to be met: (i) that the pension fund is exempt under article 153, even for the dividends received by the foreign investment vehicle; (ii) that the pension fund owns a minimum 95% interest in the foreign investment vehicle; (iii) that the foreign investment vehicle directly owns the shares in the Mexican resident entity; (iv) that the foreign investment vehicle resides in a treaty country, and qualifies to benefit from the treaty with Mexico; and (v) that the pension fund resides in a country with a treaty for the broad exchange of information with Mexico in effect.
Also, this rule incorporated relief from the 10% dividend tax that would apply to the Mexican resident entity paying a dividend to the foreign investment vehicle (different from the pension fund itself), to the extent all requirements analysed before for dividend payments were also complied with.
Therefore, although most of the issues arising from the publication of the 2014 law were resolved with these rules and regulations, new requirements and characteristics of the structures used by the pension funds investing in Mexico would need to be observed, which caused various pension funds to be 'disqualified' for the exemption they had been applying, and which had been available when they considered Mexico as an option to invest their resources.
Restructuring for non-compliant structures
On December 23 2015, new general rules for 2016 were published by the tax authorities, which included the aforementioned rules for pension funds investing in Mexico for both the primary and secondary exemption and established a transitory period for exempt structures to reorganise under the new rules.
Rule 3.18.35 establishes that pension funds that operated in Mexico through structures that do not comply with all the above requirements and characteristics but were exempt under article 248 of the old regulations, would be allowed to reorganise their investments in Mexico without triggering Mexican taxes, and without restarting the four-year rental lock-up period if:
- The reorganisation was carried out no later than June 30 2016.
- Any consideration received for the transfer of shares was made only in exchange for: (i) shares or equity participations of the acquirer of the shares; (ii) shares or equity participations of entities that are owned by the acquirer of the shares; or (iii) shares or equity participations of the person that owns the acquirer of the shares.
Should the funds reorganise their holdings under this rule, they may continue to apply the exemption based on article 248 of the old regulations up to the date of the restructuring. However, if the structure does not comply with either article 272 or 3.18.3 before June 2016, the aforementioned exemption would only apply up to December 2015.
Also, a new rule 3.18.36 establishes that the exemption under article 248 of the old regulations would continue to apply until December 2015, in any case, and that as for interest income, such exemption would only apply for interest accrued as of December 31 2015.
In some cases, restructuring the investments before the end of June may be difficult, and may become an important challenge for investment and legal teams because of the many regulatory and business situations that would need to be accommodated to restructure exactly in the way that is provided by the rules analysed in this article.
The fact that this regime was modified without advance notice for the pension funds, which resulted in additional expenses (advisory costs, restructuring expenses, and so on), has negatively impacted the image of Mexico as a country in which taxpayers can invest with certainty regarding the tax regime applicable to them and therefore the tax treatment they will receive. In some cases, a restructure might not even be possible, and the taxpayers would end up being taxed in Mexico for investments that they planned and structured with the intention of qualifying for the exemption as established by the previous provisions.
An additional concern for pension funds is based on the fact that most of these rules exist in the Miscellaneous Tax Resolution, which are administrative rules issued on an annual basis that may be modified or eliminated at any time without a legislative process, which again generates uncertainty on the application of this regime in the long term. Therefore, it is advisable – should the Mexican government wish to maintain this regime in the future – to incorporate these rules into the ITL, or at least into its regulations, in order to provide the certainty that this type of investor requires for the long term.
The author thanks Isabel Rodríguez for her assistance in the drafting of this article.
Originally published in the February 2016 issue of the International Tax Review.
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.