Although widely popular in the US and Europe since the
1980s, leveraged recapitalisations have been side-lined by tax
advisors when it comes to corporate reorganisations in
From a macroeconomic perspective, it could be argued that
this is due to the following two reasons. Firstly, financial
crises throughout the 1980s and 1990s caused uncertainty in
debt markets, spurring volatile interest rates and an overall
lack of appetite. Secondly, the 1982 nationalisation of Mexican
banks led to stagnation in the Mexican financial system,
dimming investor confidence.
Certainly, these factors contributed to the underdevelopment
of the Mexican capital market vis-à-vis peer
nations with comparable economies.
Mexico's lack of leveraged recapitalisations could also be
due to the country's disconnect with certain corporate
practices common to markets in which publicly traded companies
are the norm, particularly when one considers that the origins
of leveraged recapitalisations (arguably) lay in the desire to
fend off hostile takeovers. Mexican companies, many of which
are family businesses, have traditionally been prone to
adopting private corporate structures and are often hesitant to
It should come as no surprise then that the market
capitalisation of the Bolsa Mexicana de Valores (or BMV) in
2018 peaked at around $372.5 million, whereas the Spanish BME's
total market capitalisation in 2018 soared to around €2.03
billion ($2.2 billion). Furthermore, it was only in 2018 that
Bolsa Institutional de Valores (or BIVA), the second Mexican
stock exchange, began operations.
Nevertheless, in a relatively stable post-2008 economy, the
tides could be turning, bringing along newfound opportunities
for financially healthy Mexican companies to exploit leveraged
This article aims to highlight some key financial aspects of
these restructures and transactions, while at the same time
providing analysis on the tax ramifications of some of the most
common forms of leveraged recapitalisations under Mexican
For the sake of argument, we will refer to leveraged
recapitalisations as leveraged recaps.
Leveraged recaps can serve multiple financial purposes when
a company has unused debt capacity.
Primarily, they can significantly reduce an entity's cost of
capital, be used as a tool to harden a company's financial
discipline, as well as to reallocate idle resources to
streamline the company's corporate structure.
In the long term, leveraged recaps can have a significant
effect on a company's worth (with the corresponding risk for a
company incurring additional debt on their balance sheets). As
operating performance increases and debt is typically repaid,
these financial transactions can lead to increases in future
cash flows and earnings per share.
On an individual level, it is worth noting that leveraged
recaps can be used by majority shareholders as an efficient
portfolio diversification or exit strategy. It can even
complement employee stock option plans by allowing managers or
key personnel to acquire cheap equity in the company when debt
is issued and to later benefit from the equity's revaluation as
debt is gradually serviced.
Leveraged cash outs or dividend recaps
Leveraged recaps are often used as a means of rewarding
shareholders without denting owners' equity figures or diluting
shareholders' interest in the relevant company.
In these scenarios, the company in question may issue bonds
in debt markets or contract debt with senior and/or mezzanine
lenders in order to pay its shareholders special dividends with
Irrespective of the source of funds used to pay the
dividends, the tax consequences of a dividend payment under
Mexican law can be twofold. Firstly, at the level of the
company, the dividends are not paid out of its after-tax
profits account. Secondly, a 10% withholding tax (WHT) is
levied at the level of the shareholder insofar as the
shareholder is a Mexican tax resident individual or
Corporate tax treatment
Mexican legal entities are legally required to keep an
after-tax profits account (Cuenta de Utilidad Fiscal
Neta, or CUFIN) whose balance consists of distributable
profit that has already been subject to corporate taxation.
Generally, the balance on this account increases by the
dividends received from other Mexican entities and the net tax
profit generated each fiscal year, and decreases by the
dividends paid by the Mexican entity or profits distributed as
consequence of a capital redemption.
No tax will be due at a corporate level when dividends are
paid out of the company's CUFIN. If dividends are not paid out
of this account, the company is then required to determine the
corporate income tax due by multiplying the amount of the
dividends paid by 1.4286, and then applying the 30% corporate
It is worth noting that, to the extent certain conditions
are met, this corporate tax could be credited against the
company's own income tax liability in the relevant tax year, or
even during the two following fiscal years.
In light of the above, companies that are strapped for cash
but have sufficient earnings and balance in their after-tax
profits account could benefit from leveraged recaps by using
the debt proceeds to reward shareholders with a minimal tax
impact at the level of the company.
Tax treatment of shareholders
Under Mexican law, dividends paid to Mexican resident
individuals or non-residents are subject to an additional WHT
of 10% on the gross dividends paid.
However, it is worth noting that Mexico has one of the
largest networks of double taxation agreements (DTAs), which
may provide relief in the form of reduced WHT rates or even an
Leveraged share repurchases and capital redemptions
Leveraged recaps are also commonly used by undervalued
companies to repurchase (or amortise) shares from their
shareholders in order to bolster earnings per share, among
other corporate structure and financial goals.
From a Mexican tax perspective, repurchasing shares (or
share buybacks) would only be characterised and taxed as a
capital redemption if the total number of shares repurchased by
the company exceeds 5% of the entity's outstanding shares,
and/or whenever the re-purchased shares are not resold or
placed within a maximum period of one year following the date
If the company repurchases shares with resources obtained
from the issuance of convertible securities, the maximum period
in which such shares would need to be placed would be until the
maturity date of the issued securities.
If the abovementioned conditions are not met, no income tax
liability would be triggered for the company, and income tax
would only be due on the capital gains realised by the owners
of the shares that are being repurchased.
However, should a share repurchase be characterised as a
capital redemption, the tax consequences at the level of the
company will be as set forth below.
Income tax will be due on the portion of the reimbursement
paid to the shareholders deemed as distributed profit. For such
purposes, the distributed profit would be obtained by
multiplying the number of shares subject to redemption by the
product obtained from subtracting the capital contribution
account balance per share (known as CUCA, or Cuenta
Única de Capital de Aportación) from the
reimbursement paid to the shareholders, per share. Furthermore,
the company would be entitled to reduce the taxable basis
(distributed profit) by the balance of its after-tax profits
If the company owner's equity exceeds the balance of its
CUCA, a second calculation would be required.
This time, the distributed profit would be calculated by
subtracting the balance of the capital contributions account
from the relevant company owners' equity. If any given entity
were deemed to have distributed a profit in terms of both
calculations, then the sum obtained pursuant to the first
calculation would be subtracted from the sum obtained in terms
of the second calculation. The result would be the taxable
basis for the transaction.
The portion of the capital redemption characterised as
distributed profit would be taxed as if it were a dividend
payment. Therefore, income tax due on profits distributed in
excess of the balance on the after-tax profits account would be
assessed by multiplying the distributed profit by 1.4286, and
then applying the corporate tax rate of 30%.
Mexican individual shareholders or non-resident shareholders
would be subject to the additional 10% WHT on the distributed
profit, unless a reduced WHT or an exemption thereto can be
claimed under the applicable DTA.
Tax treatment of interest payments
Generally, under Mexican law, interest paid to Mexican
entities acting as lenders would be taxed as ordinary income.
The beneficiary owner would subsequently be required to accrue
interest payments and pay income tax at the corporate tax rate
On the other hand, non-residents would be subject to
taxation in Mexico if the capital or principal on which
interest is accrued is invested in the country, or when the
debtor is a Mexican resident, or a foreign resident with a
permanent establishment (PE) in Mexico.
Income tax due on interest payments would be levied by
withholding at the level of the Mexican debtor (the company).
The applicable tax rate could vary depending on the nature of
the transaction and the parties involved. The tax rate could
range from 4.9% to 35%. Once again, DTAs concluded by Mexico
could provide relief in the form of reduced WHT rates.
It is worth noting that by virtue of an Executive Decree
published by the Federal Gazette on January 8 2019, a tax
incentive was granted to Mexican entities required to withhold
income tax on interest paid to their non-resident bondholders
in respect of bonds listed on Mexican stock exchanges.
Generally, the incentive consists of a tax credit equivalent to
100% of the income tax that should have been withheld and paid
by the Mexican issuer.
As a result, interest paid on corporate bonds would no
longer be subject to 4.9% withholding taxes, making the
issuance of bonds a cheaper alternative.
It is worth noting that the tax incentive only applies if:
(i) the Mexican company refrains from withholding income tax on
the interest payment, and (ii) the beneficiary of the interest
payments is a tax resident of a country or jurisdiction with
which Mexico has a DTA in effect, or an agreement for the
exchange of tax information.
Obstacles to leveraged recaps
From a tax perspective, the deductibility of interest
payment poses the biggest threat to the success of leveraged
recap restructures and transactions.
Although interest payments can be deducted under Mexican
law, there are stringent compliance requirements. Among these,
the Income Tax Law establishes that interest paid by a Mexican
entity must be a strictly indispensable expense used for the
entity's corporate purpose. Namely, a direct relationship
between the expense and the revenue of the company must
Due to the subjectivity surrounding this criterion, Mexican
tax authorities have been known to challenge the link between
revenue generation and debt contracted by Mexican companies to
reward shareholders. The foregoing, on the grounds that debt
contracted for such purposes is not strictly necessary for the
performance of the businesses activities.
As such, interest paid should not be a deductible item.
Furthermore, Mexican tax authorities might return to a 1989
non-binding precedent to back their interpretation of
debt-financed dividend payments. However, the tax authorities
have not established a definitive opinion yet.
It is fairly common for Mexican companies to use
pre-existing resources to fund such cash outs, and then justify
leverage on the need for working capital, ultimately relying on
the fungible nature of cash to reinforce the link between debt
and revenue generation at the level of the company.
However, it could be argued that in order for leveraged
recap transactions to thrive, tax authorities' construction on
the revenue-expense relationship governing the deductibility of
interest payments would need to evolve in the long term.
Lastly, in relation to debt contracted between related
parties, it is worth noting that thin capitalisation rules need
to be complied with. Generally, the allowed debt-to-net equity
ratio is three to one. Since interest expenses in excess of the
allowed debt-to-equity ratio cannot be deducted, debt must be
evaluated before implementing a leverage recap scheme.
This article was written by Federico Scheffler and
Sebastián Ayza of Galicia Abogados.
Tel: +52 (55) 5540 9200
Federico Scheffler is a lawyer specialising in tax
consultancy, focusing mainly on transactional tax. He
has experience in tax consulting, international
taxation, estate planning, corporate finance, real
estate, mergers and acquisitions, venture capital and
private equity, as well as corporate restructuring.
He is a member of a number of institutions,
including the Mexican Bar Association and the
International Fiscal Association (IFA), where he is
part of the Young IFA Network (YIN).
He has a masters in business administration (MEDEX)
from IPADE, postgraduate studies in tax law from
Universidad Panamericana, and a bachelor's
degree in law from Instituto Tecnológico
Autónomo de México (ITAM).
He has been a partner at Galicia Abogados since
Tel: +52 (55) 5540 9200
Sebastián Ayza joined Galicia Abogados in 2018
in the tax practice area.
His work is focused on transactional tax matters.
His practice has specialised in corporate
reorganisations, mergers and acquisitions, as well as
national and cross-border investment fund structuring,
mainly concerning private equity and real estate
Sebastián worked from 2013 to 2018 in SMPS
Legal in the transactional tax and tax litigation
Sebastián studied law at Instituto
Tecnológico Autónomo de