The new Mexican underpayment tax rule
Francisco J Matus Bravo
Basham, Ringe & Correa, Mexico City
Basham, Ringe & Correa, Mexico City
In connection with the Base Erosion Profit Shifting (BEPS) issued by the Organisation for Economic Co-operation and Development (OECD), Mexico has been proactively applying the recommendations of the OECD to change its domestic tax legislation, sometimes even before the final reports for each action of BEPS have been concluded and released by the OECD.
In October 2019, an underpayment tax rule for deductions was approved by Congress, amending the Mexican Income Tax Law (‘MITL’). The amendment modifies Article 28(XXIII) of the MITL and entered into force on 1 January 2020. The tax consequences of such provision could impact the effective tax rate of multinationals and their current structure to carry out businesses in Mexico, therefore it is important to be aware of its content.
In general terms, the new Article 28 (XXIII) of the MITL sets forth that any payment made by a Mexican resident taxpayer to a related party directly or through a structured agreement will not be deductible for the purposes of income tax if such income is subject to tax in a preferential tax regime in the hands of its related party. For the purposes of our domestic law, an income is deemed to be subject to a preferential tax regime when it is not taxed abroad or if the income tax rate is lower than 75 per cent of the income tax rate applicable in Mexico (30 per cent).
In addition, any payments made by a Mexican taxpayer to a related party directly or through a structured agreement will not be deductible for purposes of the MITL even if such income is not subject to a preferential tax regime if the recipient of the income (directly or indirectly), disposes of such funds to carry out deductible payments to other members of the group (another related party) directly or through a structured agreement and such payments made to the other related party are subject to tax in a preferential tax regime.
The foregoing is assumed, unless proven otherwise, when the recipient of the income (which is not subject to tax through a preferential tax regime), makes deductible payments that are considered by the other member of the group (another related party) to be an income subject to a preferential tax regime, if the amount thereof is equal to or greater than 20 per cent of the payment made by the taxpayer.
However, the third paragraph of Article 28(XXIII) sets forth an exemption for this rule. The tax treatment described above (non-deductible payments), shall not apply to payments made by Mexican resident taxpayers if the payment is related to business activities carried out by the recipient of the payment (foreign related party) even if such payment received by the related party is subject to a preferential tax regime. This exception applies only if the following requirements are met:
- the recipient of the payment can prove that it has the necessary personnel (employees) and assets to carry out the entrepreneurial activity;
- the recipient is a resident for tax purposes and was incorporated in a country or jurisdiction that has a broad agreement in force with Mexico for the exchange of information and its main administration of the business is located therein;
- the payment is not considered subject to a preferential tax regime because of a hybrid instrument or mechanism. It is considered that there is a hybrid mechanism, when the national (Mexico) and foreign fiscal legislation characterises a legal entity, legal figure, income or the owner of the assets or a payment differently and, as a result, a deduction is granted in Mexico and the income received by the recipient is not subject to tax or is partially subject to tax; and
- the payment is not attributed to a permanent establishment or branch of a related party of the Mexican taxpayer nor the recipient of the payment.
Thus, it is possible to conclude that if a Mexican taxpayer carries out a payment to a related party and such income is subject to tax in a preferential tax regime in the hands of its related party, the payment will be deductible in Mexico if the requirements pointed out above are met.
Even though the business activities exception for this new rule exists, taxpayers have several doubts regarding the interpretation and application of this new disposition that have not been clarified by the tax authorities and most likely will not be clarified by them, for example:
1. which evidence is sufficient to prove that a company has assets to qualify for the exception?;
2. is there a proportion between assets and activities to qualify for the exemption?; and
3. do some services, as shared service centres, qualify for the exception?
Moreover, there are other exceptions that allow deduction of payments made to the foreign resident. One worth mentioning is that this new disposition shall not be applicable whenever a payment is subject to the withholding tax rate of 40 per cent on income from sources of wealth located in Mexican territory obtained by residents in a preferential tax regime.
Taxpayers should carefully analyse their current structures in order to reduce the risk that could arise from this new Mexican underpayment tax rule, in part because the Mexican government has been carrying out intense audits that lately have become a public concern and are under the scrutiny of the media and the people.
Business activities are considered any commercial activities under Mexican Federal Law.