Mexico’s transfer pricing update – A rapidly changing post BEPS environment
In the hype of the BEPS Project, Mexico has been one of the most active countries in applying the concepts of substance, transparency and consistency, write Simón Somohano and David Cárdenas of Deloitte.
This has been done either by enacting domestic tax legislative changes or by using the OECD's advice when practicing reviews to domestic taxpayers.
Long before the final BEPS actions were published on October 2015, the Mexican Tax Authorities began issuing different rules inspired by the OECD's draft recommendations.
A few years ago, rules were introduced in order to limit the deduction of interest payments with related parties, either if the principal generating the interest is not used in the business activities of the taxpayer or if the interest derived from borrowings is higher than interest derived from lending, or if the debt to equity ratio of the taxpayer is higher than three to one. Anti "back-to-back" financing rules were also encouraged by the BEPS plan in its early stages.
The disclosure of aggressive tax planning is not unusual for Mexican taxpayers. Since 2015, a special tax informative return named format 76 (relevant transactions) has required companies to report non-recurring, foreign-entity transactions considered by the tax authorities as aggressive tax planning. Companies must also report foreign-initiated and self-initiated transfer pricing adjustments that deviate from the inter-company transactions original value.
Neutralising effects of mismatches of different tax treatments has also a long-running feature of the Mexican legislative agenda. Since 2014, payments made to any entity are non-deductible if the recipient of such payments is subject to a preferential tax regime, unless it can be proved that the amount of the consideration was at arm's length. The provision does not specify whether or not the payment has to be made to a related party. Further rules provide that any payments are non-deductible if they are also deductible by a related party, residing either in Mexico or abroad, and in the case of interests, royalties and technical assistance, payments are considered non-existent in the country or territory where the foreign entity is located or are not considered as taxable income.
The transfer pricing environment is clearly not an exception to the theme of the tax regulation framework in Mexico. The rules follow the OECD principles and, from 2016 onwards, taxpayers will need to fulfill the three levels of documentation mandated by BEPS Action 13.
How Action 13 has been implemented in Mexico
The Mexican government introduced BEPS Action 13 by adding Article 76-A to the Mexican Income Tax Law (MITL). The Mexican adoption of this action requires taxpayers to provide three levels of documentation in the form of three additional tax returns. These new tax returns do not substitute the annual obligation to prepare a transfer pricing report, among other formal obligations.
In particular, these tax-informative returns seek to incorporate in Mexican law the effects of documents guidance on transfer pricing documentation and country-by-country (CbC) reporting and country-by-country implementation package (CbC-IP), issued by OECD in September 2014 and June 2015 respectively.
The names of the aforementioned tax returns follow the same definitions as the OECD, a master file, a local file and a CbC report.
The master file will require obligated taxpayers to disclose the multinational enterprise's (MNE's) global operations, its organisational structure, key profit drivers, intangible assets, supply chain, inter-company financing and financial and tax positions.
The local file is essentially in line with Mexico's documentation rules, and will also require a description of the organisational structure, business and strategical activities of the taxpayer, detailed information about inter-company transactions and the financial data used to test if said operations were performed at arm's length, for both the analysed entity and the comparable companies/transactions.
Also a CbC report following the OECD recommendations was introduced. This file will require taxpayers to submit quantitative and qualitative information about every affiliated company within the MNE. The pieces of financial and tax information required by jurisdiction are revenues with related and non-related parties, profit (or loss) before income taxes, income taxes paid and accrued, stated capital, accumulated earnings, headcount and tangible assets. Finally, the CbC report will require a list of all the affiliated companies (including permanent establishments) of the MNE describing its place of incorporation, tax residence and its economic activity.
The taxpayers with revenues higher than approximately 644 million pesos ($37,000,000) will be compelled to prepare the master and local files. Companies using the new integration option (tax consolidation), state companies and permanent establishments are subject to this new requirement.
As advised by the OECD, the CBC report in Mexico is only intended to be filed by Mexican MNEs reporting revenues higher than 12 billion pesos. However, Mexican Tax Authorities reserved the right to require the CbC report to taxpayers in Mexico that are subsidiaries of a foreign company if the report cannot be obtained through the information exchange protocols with a tax treaty country.
Failing to comply with these new requirements will produce a pecuniary fine of around $8,000 to $11,500, as stated in the Federal Tax Code. Moreover, consequences of non-compliance includes potentially more costly, non-monetary penalties such as the non-compliant taxpayer being banned from performing business transactions with the Mexican government and the suspension of the importers registry. In addition, non-compliant taxpayers cannot receive any subsidies and incentives from the federal government. The new regulations entered into effect on January 1 2016, and the deadline for filing the first informative returns is December 31 2017. Thereafter, the deadline for filing the informative returns is December 31 of the following year.
It is important to note that the content of the CBC report is applicable to Mexican law insofar as it is referred to the transfer pricing guidelines, as long as its content is not inconsistent with the MITL, while the CBC-IP is not valid from a legal standpoint in Mexico per se. Moreover, Article 76-A does not refer to these documents. As a result, the wording for the CbC tax return is unclear. For example, the process of "assignment" (equivalent to "reporting entity" as noted in the CBC-IP) cannot be understood in isolation; nor is it clear what happens in cases in which Mexico has not concluded a double taxation treaty with the country of residence of the entity to be established as responsible for the preparation of this statement.
The provision creates legal uncertainty when its scope is unclear in some respects. Terms such as "financial position and fiscal" are not specific, although they refer to quantitative data; while terms such as "activities" or "strategic" involve very broad concepts. Furthermore, the provision does not indicate its adherence to the standards outlined in the CBC-IP report and finally, the proposed standard left to the tax authorities to determine the general rules for presenting information, including media and formats, as the possibility of requesting "additional information", without delimiting or clarifying the scope of it.
Mexican tax officials have stated in public forums that a public consultation would be carried out before publishing of the formal rules that will describe the reporting formats of the aforementioned tax informative returns. The expectation is to issue these long-awaited final formats before the end of 2016.
The introduction of article 76-A will provide a greater knowledge and transparency of MNEs operating in Mexico while imposing new administrative burdens on taxpayers. The challenges faced by Mexican MNEs are the readiness to compile information that most of the time cannot be obtained from a single source. Additionally, the master file will require proper coordination of Mexican subsidiaries by foreign MNEs with their headquarters to obtain information that might be not domestically available. Finally, nowadays Mexican taxpayers disclose relevant information regarding their transfer pricing documentation in another tax return and some appendixes of the tax statutory report. Therefore it is advisable for taxpayers to maintain a uniform approach in order to ensure that repetitive data is properly filled and consistently reported to the tax authorities. Also a review of which information might be redundant will ease the administrative burden of the taxpayer.
Cost sharing agreements
Another improvement regarding the deduction of cost shared to Mexican affiliates or commonly known as pro rata expenses, is that Mexican tax authorities will no longer deny the deduction of allocated expenses if Mexican taxpayers maintain supporting documentation and comply with all the requirements established in the MITL regulations.
For residents of treaty countries, such prorated expenses are allowed to be deducted if, in addition to the general deductibility requirements included in the published regulations (the expenses must be necessary for the company to carry out its activities; there must be a reasonable connection between the expenses incurred and the benefit received, or expected to be received, by the company; the expenses were incurred between related parties; the taxpayer must demonstrate that the allocation was agreed on at arm's-length terms, etc.), certain transfer pricing documentation must be maintained for prorated expense transactions between related parties.
Every single requirement in the published regulations must be met to certify there is a reasonable relationship between the expenses incurred and the benefit received, or expected to be received, by the taxpayer that incurred the expenses. The requirements are as follows:
Each party to the shared expense agreement must have access to the details of the transaction, how the anticipated profits will be determined, the prorated expenses incurred, and the profits received.
The participants must be companies that will mutually benefit from the agreement.
The agreement must specify the nature and scope of the benefits that will be available at a global and an individual company level with respect to the expenses incurred and prorated among the members of the group.
The agreement must provide for prorated expenses using an allocation method that reflects the expenses in relation to the anticipated profits.
The agreement must specify the scope of the transactions covered and the term of the agreement.
The following transfer pricing documentation must be retained for each transaction, otherwise the expenses will not be deductible:
Name, country of incorporation and tax residence, country where the company has its management headquarters, tax domicile, and tax ID number of each related party involved in the prorating of global expenses or that will benefit from the prorating;
Description of the transactions and the terms of the agreement;
Functions and activities performed by each party, as well as the risks assumed and assets used by each party;
Documentation supporting the global expenses incurred;
Details and documentary evidence that the expenses were paid and prorated per the agreement;
Documentation demonstrating that the transactions were carried out on arm's length terms and the transfer pricing method used;
Documentation showing how comparable operations/companies were determined for each transaction; and
Supporting documentation regarding future transactions, projections used as a basis for calculating pro rata expenses and expected benefits, as well as pro-rata expenses effectively incurred and benefits effectively received.
This regulation surely represents an effort to recognise the OECD's recommendations and, if followed properly, many taxpayers can gain certainty in their shared expenses transactions. However, the burden of proof required should not be understated, since the regulations fail to provide specific guidance for documentation purposes in key aspects such as, for instance, "reasonable relationship", "expected benefits", "benefits effectively received".
Since the last tax reform came into effect from fiscal year 2014, the maquiladora regime for income tax purposes requires such entities to file an advance pricing agreement (APA) before the Mexican Tax Authorities or apply the safe harbour rule stated in the MITL. A large number of maquiladoras decided to apply for an APA seeking arm's length compensation to avoid potential double taxation when using the aforementioned tax rule. According to Mexican Tax Authority officials, approximately 700 APA requests have being filed since the new regulations were enacted.
There has been proactive interaction between taxpayers, authorities and practitioners related to this matter. The communications with the tax authorities have been coordinated by the National Export Manufacturing and Maquiladora Industry Council (INDEX) and have been key to make progress into the negotiations. The INDEX recently issued a bulletin reporting on the outcome of meetings relating to issues involving the conclusion of maquiladora APAs. To obtain an APA, a maquiladora must reach an agreement with the tax authority transfer pricing officials about the functions, assets used and risks bared by the maquiladora, the transfer pricing method applied, third-party comparable companies used, among other relevant details.
The tax authorities are aware of the challenge represented by processing such a large number of APA requests, therefore they have proposed a methodology to "fast-track" the administrative burden. In particular, the proposed fast track methodology by the tax authorities considers, amongst other items, the following assumptions:
a) Business classification based on the intensity of factors of production used (labour or operating assets);
b) The profit margin is determined on an annual basis following the business classification procedure (different approach to the fixed profit margin application for the period that the APA covers);
c) If the fast track methodology is feasible, maquiladora companies would have to notify the tax authorities in accordance with the APA request, and therefore the tax authority would issue an APA ruling within the required legal timeframe; and
d) Companies for which the fast track methodology is not feasible will continue with their APA negotiation with the terms of the proposed methodology in the APA request. This last issue is particularly important, since the fast track methodology is not intended to be applicable to all cases, but to those maquiladora companies that are primarily labour-intensive. For significant asset-intensive companies, the fast track methodology proposed by the tax authorities can result in double digit profit margins, which may not be consistent with the business' economic reality.
The proposed fast track methodology does not represent an alternative compliance option to that of an APA or by the safe harbour). Instead, it seeks to settle the APA requests submitted by some maquiladora companies, as long as the application of this methodology demonstrates similar and reasonable results to the ones requested by companies in their APA applications in the context of the mutual agreement procedure (MAP) between the governments of Mexico and the US.
Based on recent meetings with tax authorities, in order to apply the proposed fast-track methodology, a group of comparable companies were selected by SAT based on the most representative industries of the maquiladora companies that are asset intensive: (1) Automotive and auto parts; (2) Electronic and (3) Miscellaneous. The maquiladora companies that cannot be classified into the first two groups, such as those operating in plastics, textiles, furniture and healthcare, will be classified into the third group.
Considering that there are several pending issues, most notably the profit margins required under the fast track methodology that still need to be addressed in the negotiation process with tax authorities, several details of the fast track methodology are yet to be defined or agreed by INDEX with the tax authorities.
Other Mexican TP highlights
Recently the Mexican tax authorities issued a set of rules through the Omnibus tax ruling clarifying the procedure to ask for transfer pricing queries before the Mexican tax authorities. Aside from the formal process, the rule introduces the possibility that the functional analysis may be performed by the tax authority itself at the premises of the taxpayer. The taxpayer will be informed via the tax mailbox, and on each visit of the tax authority a form will be issued containing the general information of the taxpayer, the names of the people and legal representative(s) present during the procedure, the relevant facts and sayings of the procedure including the information provided by the taxpayer, the agreement reached and the next steps to complete the functional analysis.
This measure can add transparency to both the taxpayer and the tax authorities during special transfer pricing queries and to jointly develop a functional analysis that may latter produce a better economic analysis and a reasonable conclusions.
Mexico is experiencing rapid changes in transfer pricing, from the adoption of BEPS to the resolution of maquiladora companies APAs to an increase scrutiny of transfer pricing compliance. Taxpayers should understand the nature and extent of these changes and plan in advance in order to reduce the exposure to adjustments and other penalties. Technology-based solutions to address the new disclosing requirements paired with expert advice can provide the much needed guidance to successfully navigate this rapidly changing environment.
Lead partner, transfer pricing services, Latin America & the Caribbean region
Deloitte Galaz, Yamazaki, Ruiz Urquiza, S.C.
Paseo de la Reforma 489, piso 6
Col. Cuauhtémoc, 06500, México D.F
Tel: +52 (664) 622-7872
Simón Somohano is a tax partner based in in Mexico City and Tijuana responsible for Deloitte's transfer pricing practice in Latin America and the Caribbean Region.
He has more than 25 years of experience in the application of tax, economic and financial criteria in transfer pricing, anti-dumping/subsidy investigations, valuation analysis of intangibles, double tax treating issues, planning, business model optimisation, structuring and economic consulting.
Under his leadership, Deloitte's regional transfer pricing practice has been consistently recognised as one of the leading practices in Latin America.
He has consistently been named as one of the world's leading transfer pricing advisers in the Transfer Pricing Expert Guide published by the prestigious Euromoney Legal Media Group.
His clients include several Fortune 500 multinational companies doing business in Mexico. He has extensive experience and a successful track record leading the Mexican negotiations of advance pricing agreements (APAs); mutual agreement procedures (MAPs) and transfer pricing examinations with Mexican and foreign authorities, teaming with colleagues in Deloitte's global transfer pricing network.
Simón advises in a variety of industry sectors, mainly automotive and manufacturing, banking and insurance, retail and consumer goods, real estate, technology and the energy and resources market.
He also provides specialised counselling to clients in several anti-dumping and subsidy investigations.
Simón is a frequent guest speaker in international business forums in Mexico and abroad.
He has authored various articles on Transfer Pricing in specialised journals and is a co-author of Transfer Pricing International Handbook: A Country-by-Country Guide published by the International Tax Institute and Transfer Pricing: A Theoretical, Legal and Practice Framework, published by the Institute of Chartered Accountants (Mexico).
His is a board member of the Transfer Pricing Committee of the Institute of Chartered Accountants and the lead transfer pricing advisor to the National Export Manufacturing and Maquiladora Council (INDEX). He has also been certified as a financial consultant from Mexico's Securities and Banking Commission.
He holds a MSc degree in economics and finance from Warwick University's business school (UK) and a
BA in economics from Universidad Panamericana (Mexico City).
Economist and transfer pricing partner
Deloitte Galaz, Yamazaki, Ruiz Urquiza, S.C.
Paseo de la Reforma 489, piso 6
Col. Cuauhtémoc, 06500, México D.F
Tel: +52 (55) 5080 6453
David Cárdenas is an economist and transfer pricing partner in the Mexico City office of Deloitte Touche Tohmatsu's Mexican member firm.
For more than 15 years he has participated in engagements involving various tax controversy situations, negotiation and implementation support for advance pricing agreements and competent authority procedures with the tax authorities, design of inter-company pricing methodologies, valuation of businesses and intangible property transferred in inter-company transactions and preparation of transfer pricing documentation.
David has managed many inter-company pricing projects for some of the largest Mexican multinational companies and their foreign subsidiaries in a wide range of industries, including transportation, energy, telecommunications, agriculture, food and beverages, automotive, pharmaceuticals, real estate, and financial services.
David has coordinated global transfer pricing documentation engagements with his colleagues from Deloitte's global network and has been in charge of coordinating the transfer pricing documentation for foreign subsidiaries of US multinational companies in Latin America and the Caribbean region.
David leads Deloitte Mexico's life sciences and healthcare tax and legal services practice. He is a co-leader of the energy and resources sector in the tax practice, and an active contributor to the firm's technology, media, and telecommunications and automotive sectors.
He is the co-author of an article entitled "Mexico's new transfer pricing reporting obligations will result in increased audit activity" in Tax Management International Journal (2009).
David earned a bachelor's degree in economics from the Instituto Tecnológico Autónomo de Mexico (ITAM).