Navigating Mexico’s 2020 tax reform in the context of US investments for high net worth individuals
Back to Private Client Tax Committee publications
Alejandro Santoyo
Creel, Mexico City
Eduardo Brandt
Creel, Mexico City
In this article, the authors discuss the myriad of changes to Mexico’s entity classification rules and controlled foreign corporate (CFC) regime. Such changes potentially affect Mexican resident individuals that have elected to use offshore limited partnerships to conduct their investments in ‘US situs assets’. Mexican resident individuals investing through these vehicles may face different income tax rates, different income characterisations and disclosure requirements.
As part of its 2020 tax reform, Mexico has enacted new entity classification rules and several corrections to its CFC regime. Under new article 4-B of the Mexican Income Tax Law (MITL), Mexican resident individuals will be required to recognise items of income derived through both foreign fiscally transparent entities (ie, vehicles with legal personality under their laws of formation) and legal arrangements (ie, vehicles without legal personality under their laws of formation) for purposes of determining their Mexican tax liability.
Prior to this new provision, Mexico followed the construct of legal personality to determine whether items of income derived through a foreign fiscally transparent entity or legal arrangement should have been attributed at the level of the vehicle or the members. For these purposes, an entity or legal arrangement should be considered fiscally transparent whenever a two-pronged test is met:
- the entity or legal arrangement is not considered a tax resident under the laws of the jurisdiction of formation, administration or place of effective management; and
- items of income are attributed to its members under such laws.
In addition, prior to the 2020 tax reform, Mexico´s CFC regime required Mexican resident individuals who exercised effective control to recognise on a current basis certain types of income derived through foreign resident entities, foreign fiscally transparent entities and foreign fiscally transparent legal arrangements. Article 176 of the MITL was modified to exclude foreign fiscally transparent entities and legal arrangements from the purview of the CFC regime, given that Mexican taxpayers will be required to recognise any items of income derived through such vehicles under Article 4-B of the MITL.
Therefore, as of 2020, a Mexican resident deriving certain types of income through a controlled foreign entity may be required to include such income on a current basis under Mexico's CFC regime. Meanwhile, items of income derived through a foreign fiscally transparent entity or a legal arrangement will be includable to the Mexican resident under Article 4-B of the MITL.
Mexican resident individuals investing in the United States generally invest through a foreign vehicle to manage the US estate tax. Thus, Article 4-B of the MITL and Mexico’s CFC regime become relevant to such investments. Under the US estate tax, non-resident aliens may be subjected to a 40 per cent estate tax on the value of their ‘US situs assets’ which includes US real property and investments in stock issued by entities incorporated in the US. Therefore, Mexican resident individuals often interpose vehicles, which are treated as a foreign corporation for US tax purposes, to manage the impact of the US estate tax on their US situs assets.
Ontario limited partnerships (Ontario LP) became a common vehicle to manage the US estate tax for Mexican resident individuals investing in the US. From a Canadian perspective, Ontario LPs generally do not have legal personality or capacity, and are not liable for Canadian taxes on any of the items of income they derive, which makes them tax neutral for investors. From a US perspective, the Ontario LP is treated as a ‘business entity’ under Treas. Reg. 301.7701-2. It can file the so called ‘check-the-box election’ and elect to be treated as a foreign corporation for US federal tax purposes, which allows the Mexican investor to avoid holding US situs assets directly.
From a Mexican tax perspective, given that Ontario LPs should be considered as foreign fiscally transparent legal arrangements, they were subject to Mexico’s CFC regime prior to the 2020 reform. This allowed certain Mexican resident investors to take advantage of a couple of technical glitches in the CFC rules. For example, before it was modified, Article 177 of the MITL provided that the tax triggered on income subject to Mexico’s CFC regime would be computed using the Mexican corporate tax rate of 30 per cent, which allowed Mexican resident individuals – who are generally subject to a 35 per cent income tax rate – to reduce their effective tax rates.
Further, some investors were able to take the position that the 10 per cent tax imposed on Mexican resident individuals on foreign distributions did not apply under the CFC regime, as such tax was not provided with respect to deemed income inclusions under the CFC regime. Both of these oversights have been corrected as part of the 2020 tax reform: any income inclusion under the CFC regime would trigger a 35 per cent tax for Mexican resident individuals and subsequent distributions of cash would also trigger the 10 per cent domestic tax, despite the fact that the income associated with such cash distribution was included as CFC income.
Further, the use of Ontario LPs allowed certain Mexican resident investors to cherry-pick the treatment of income derived through the Ontario LP. Under Rule 3.18.25 of the Tax Miscellaneous Resolution for 2019, Mexican resident investors participating through a foreign fiscally transparent legal arrangement were able to ignore the existence of such arrangements for the purposes of applying the 40 per cent withholding tax provided under Article 171 of the MITL – which would otherwise apply to payments made to a foreign legal arrangement. Such rule also provided that Mexican resident individuals participating in such legal arrangements were not required to include as CFC income any items of income dealt with in Rule 3.18.25, provided they recognised such items of income directly. The existence of this rule allowed Mexican resident individuals to take the position that the sale of publicly traded stock held through an Ontario LP could qualify for the 10 per cent preferential rate under domestic law because, although the holder of record of the stock was the Ontario LP, Mexican resident individuals could opt out of the CFC regime under Rule 3.18.25 and consider they derived the gains directly.
Unfortunately, the statutory language of Rule 3.18.25 rule was not entirely clear as to whether it applied solely in the context of items of income that would otherwise be subject to the 40 per cent withholding tax (ie, Mexican source of income) or if it stood for the proposition that it could apply with respect to foreign source gains and other items of income. While the correct policy result could have been to ignore the foreign fiscally transparent legal arrangement, both for purposes of Mexican and foreign source items of income, the reference in Rule 3.18.25 to items of income subject to Article 171 of the MITL makes it unclear.
Given that foreign legal arrangements are now excluded from Mexico´s CFC regime, the lack of clarity in such guidance is now a moot point. Under the current rules, since Article 4-B of the MITL would treat any Mexican investors as deriving directly the items of income realized through a foreign legal arrangement, any gains received through an Ontario LP on the sale of stock would be taxed in the hands of the Mexican resident individuals as if they had received the income directly. Thus, individuals should be able to benefit from the 10 per cent preferential rate.
Conversely, given that Mexico’s CFC regime excludes income received through foreign legal arrangements, individuals would be taxed at the individual tax rate of 35 per cent on any other items of income as if they had received the income directly. With the inclusion of Article 4-B of the MITL, any cash distributions associated with gains from the sale of property that has already been included in taxable income should not trigger the 10 per cent domestic tax on foreign distributions, since Mexican resident individuals are considered to realise the item of income directly.
Despite the fact that Ontario LPs can be used effectively for planning techniques, they do come with the downside of triggering reporting disclosures with the Mexican tax authorities. Under Article 178 of the MITL, Mexican resident individuals holding an interest in an Ontario LP are required to file an informative return with the Mexican tax authorities by February of each year. While this filing does not have any tax consequences, investors are generally reluctant to file these types of informative returns due to privacy and security concerns. More importantly, failing to report or reporting after the due date is regarded as a tax crime – sanctionable with a prison sentence.
In order to manage the filing of these informative returns with the tax authority, Mexican resident individuals may also consider the use of contractual arrangements under Mexican laws with the equivalent legal effects as the Ontario LP (MX partnership). As long as the MX partnership lacks legal personality/capacity under Mexican domestic law, and the income derived is attributed to its members, Mexican resident individuals should have the same tax treatment that they would have had if they were using Ontario LPs.
It is important to note that MX partnerships should not conduct entrepreneurial activities; otherwise, they would have the same tax treatment as a Mexican legal entity and the tax transparency for the members vanishes. Rule 2.1.14 of the Tax Miscellaneous Resolution for 2020 provides a ‘safe harbour’ test to determine that, when at least 90 per cent of the income realised by the MX partnership is considered passive in nature (ie, interest capital gains, dividends, etc), the MX partnership should not be considered to be carrying on entrepreneurial activities.
Given that the MX partnership may conduct a trade or business, financial operation or may provide for the division of profits and losses between members, the MX partnership should be treated as a business entity under Treasury Regulation 301.7701-2. As such, an MX partnership may file a ‘check-the-box’ election and elect to be treated as a corporation for US federal tax purposes.
Due to the fact that the MX partnership can be treated as a foreign corporation for US purposes, Mexican resident individuals may be able to manage the US estate tax and avoid US situs asset characterisation with respect to the US investments which are contributed therein. Since the MX partnership would generally be structured so that it does not conduct entrepreneurial activities, or to comply with the safe harbour under Rule 2.1.14, items of income derived through the MX partnership should be considered realised directly by its members. Therefore, with a MX Partnership, Mexican resident individuals can enjoy the same benefits of an Ontario LP without being subject to the obligation to file an informative return, as the MX Partnership is not a foreign legal arrangement.
The 2020 Mexican tax reform contains a myriad of changes to the tax treatment of foreign entities and Mexico’s CFC regime. Mexican resident individuals should evaluate how these changes affect their investments held through foreign vehicles, as the treatment of these vehicles and the income they attribute has changed.
Back to Private Client Tax Committee publications