In general terms, Mexican tax treaties have followed the special provisions under chapter VI of the Model Tax Convention on Income and on Capital of the OECD, such as provisions proposed therein under article 24 concerning the non-discrimination principle.
Under the context of the non-discrimination principle, the Mexican Income Tax Law (MITL) has incorporated legitimate distinctions recognised by the OECD such as those based on different circumstances, such as liability to tax and ability to pay, as well as unjustified differences that could be considered as a discriminatory feature under international standards.
The OECD Model Tax Convention and the income tax treaties in force, recognise two types of discrimination: direct discrimination, when the subject of the discriminatory practice is the nonresident itself, and the indirect discrimination, where the subject is a resident company or individual and not the non-resident.
An unjustified tax treatment provided in the MITL which gives rise to indirect discrimination is provided under article 32, section XVIII, which provides that pro rata expenses made abroad with nonresidents are non-deductible. The term pro rata expense is not further clarified under this law.
Article 32, section XVIII, of the MITL reads as follows:
“Article 32.-For the purposes of this Title [applicable to corporate entities], the following are not deductible:
XVIII. Pro rata expenses incurred abroad with persons who are not taxpayers of the income tax pursuant to Title II [applicable to resident corporate entities] or IV [applicable to resident individuals] of this Law.”
The lack of neutrality in the tax treatment concerning the allocation of expenses (pro rata expenses) has affected multinational enterprises which under acceptable business models centralise their functions, assets and risks, for competitive positioning in order to produce benefits for several members of their organization situated in different jurisdictions.
Based on article 32, section XVIII, the Mexican tax authorities have being undertaking an extensive audit program in this regard, covering different sectors, considering the existing pressure on the group service centers to allocate expenses abroad and the perception that abuse may exist in some circumstances that would result in the erosion of the national tax basis by shifting income abroad, through payments made by a resident taxpayer to its non-resident related parties.
As mentioned before, considering that Mexican income tax treaties protect taxpayers against this type of differential tax treatment concerning payments made abroad, that include expenses that are allocated to a Mexican resident, a violation under the indirect discrimination provision pursuant to paragraph 4 article 24, can be invoked when the controversy prevails under the grounds of article 32, section XVIII.
Paragraph 4 of article 24 or 25 (non-discrimination), as the case may be, reads as follows concerning the indirect discrimination:
“4. Except where the provisions of paragraph 1 of article 9 (Associated Enterprises), paragraph 8 of Article 11 (Interest), or paragraph 5 of Article 12 (Royalties) apply, interest, royalties, and other disbursements paid by a resident of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable profits of the first-mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State.”
In the course of an audit, concerning interpretation of section XVIII of article 32, the Mexican tax authorities have followed a form over substance approach, being a civil law country, instead of a desirable substance over form approach. It should be noted that the audits in this area normally cover other formal and substantial domestic issues that may strengthen the tax authority position to challenge headquarter allocation of expenses, situation that can result in a more complex controversy.
Under this environment numerous disputes have arisen, especially, in cases where indirect charge methods are involved, even in cases where a treaty is in force and taxpayers have met the OECD arm’s-length standard and Transfer Pricing Guidelines (which accept indirect charge methods), both applicable under the Mexican tax legislation.
Considering risks involved, taxpayers have followed different approaches in this regard. Some taxpayers have elected not to deduct those charges; others, have decided to implement international best practices that provide very high standards of support and compliance in sustaining deductions of intra-group charges in Mexico, either on a preventive basis, or during the different stages of the controversy.
In some instances, tax controversies have been successfully solved during the audit process (where international best practices were applied), others are expected to be solved through competent authority processes pursuant to the existing income tax treaties, and few others have been dealt with through an administrative appeal and litigation.
Although litigation in this area has been normally utilised as the last resort, considering the uncertainty that arises from the MITL and the fact that the Mexican tribunals normally follow a form over substance approach, as well as the strong trend of the courts to rule in favour of the tax administration, the need to effectively avoid double taxation has led taxpayers to go to court, especially in situations where taxpayers need to exhaust domestic remedies to be able to apply foreign tax credits in their home country where the costs have been incurred.
It is worth mentioning that advance pricing agreements have not been utilised in this area, however, they may prove useful to resolve actual or potential disputes, as an alternative to the traditional dispute resolution techniques. This strategy has to be decided on a case by case basis under a consistent global approach.
Case law
During 2011 there were successful litigation processes where the Tax and Administrative Court ruled in favor of Mexican taxpayers confirming the deductibility of intragroup charges, notwithstanding article 32, section XVIII.
The Federal Court of Tax and Administrative Justice ruled in January 2011 in the trail number 13403/09-17-01-4/503/10-PL-07-09 the following.
Under article 25 (non-discrimination), paragraph 4, of the income tax treaty in force between Mexico and the US, it was agreed by the contracting states to follow the principle of indirect non-discrimination, to avoid discrimination under the domestic laws of each of the contracting states with respect to interest, royalties and other disbursements paid by a resident of a contracting state to a resident of the other state and which should be deductible in the first state and not challenged under the argument that these items of income were made to a resident of that other state.
Further, the court addressed that it was evident that this principle was agreed to concede the same treatment applicable to payments made to a nonresident, to those made to a resident under the same conditions.
Based on the above-mentioned considerations, this court ruled that if the tax authority determined a tax liability challenging the deduction made by a Mexican resident of pro rata expenses made to a non-resident pursuant on article 32, section XVIII, this meant a violation to the indirect non-discrimination principle, which prevails over domestic law, provided that the exceptions contemplated under paragraph 4 of article 24 (non-discrimination) did not apply.
As can be derived from this decision, the court also recognises that under paragraph 4 of the non-discrimination article, there are some exceptions that allow a differential tax treatment concerning expenses, in cases where the taxpayer maintains a special relationship with the recipient. This paragraph specifically refers to articles 9 (associated enterprises), paragraph 1, article 11 (interest), paragraph 6 and article 12 (royalties), paragraph 5.
Article 9, paragraph 1, provides for the adjustment of income of a resident of a contracting state where in its dealings with a related non-resident company conditions differ to those applicable to transactions between independent parties.
The references to article 11 and 12 cited above deal, respectively, with interest or royalties paid by resident of one of the states, to a resident of the other state. Paragraph 5 and 6 of such articles, provide that the limitation to tax at source provided under such articles does not apply where by reason of a special relationship between the payer and the recipient of the income, the amount of the income (interest or royalties) exceeds the amount that would have been agreed by independent parties.
In Trial number 13403/09-17-01-4/503/10-PL-07-09, the court ruled, in January 2011, that article 25, paragraph 4, of the convention between Mexico and the US was an agreed general rule dealing with the prohibition of contracting states to indirectly discriminate for deductions applicable to residents in relation to interest and royalties or other disbursements, except where the income was not determined pursuant to the arm´s-length principle that could result in undue benefits for related companies that form part of an economic group distorting tax revenues.
It is important to note that these two decisions are not final, since the Mexican tax authorities have challenged these rulings.
The same court has ruled on other two cases, which have not been made public, concerning the issue of pro rata expenses and the indirect discrimination principle provided under the income tax treaties. These two additional precedents have been also favorable to taxpayers and, as was the case of the other two rulings, the Mexican tax authorities have challenged both decisions of this court.
One case involved a direct charge of expenses made by a US resident to a related Mexican resident taxpayer which were reimbursed by the Mexican resident. The expenses were incurred by the US resident in the course of an acquisition of a division that was owned by related parties which were resident in different jurisdictions. This transaction produced significant benefits to the whole group, including the Mexican taxpayer, and the charges were fully identified and supported, and made pursuant to the arm´s-length principle.
The Mexican tax authority challenged the deduction considering that the expense was pro rata under article 32, section XVIII, and then further argued before the court that the discrimination principle was not applicable based on what has been considered as weak grounds. One of the statements made by the tax authority before the court to deny the right to apply of the non-discrimination principle was that being the parties related, the exception under paragraph 4 of article 25 should apply (article 9, paragraph 1) and, thus, a differential treatment could be sustained.
The plaintiff argued that the expense was not pro rata in terms of article 32 and supported its defense on the historical interpretation of such article (this article was first introduced in 1959 where there was no tax treaties or exchange of information agreements in force in Mexico), a document issued by the Congress at the time this provision was introduced, on the OECD Transfer Pricing Guidelines and on the indirect non-discrimination provision of the Mexico-US income tax treaty.
The court ruled that the expense was pro rata but pursuant to the treaty, indirect discrimination principle the expenses were deductible.
Based on these cases, a trend to favor taxpayers against article 32, section XVIII can be observed from the Tax and Administrative Court.
More certainty
In the near future taxpayers may have more certainty in this area when more cases are solved through the traditional and non-traditional dispute resolution mechanisms. The trend of the Tax and Administrative Court, mentioned above, which reaffirms and validates international accepted principles (indirect non-discrimination) hopefully should be followed in other instances (Circuit Tribunals and Supreme Court Constitutional Courts).
A positive resolution under any dispute resolution strategy is very relevant in the context of the global economy where an accepted and widespread business model around the globe is to continue centralising functions, assets and risks within multinational groups of enterprises.
Compliance with transfer pricing and other domestic requirements should not be taken lightly to ensure treaty protection and a favorable result either before the Mexican tax authorities or the Courts. Defense files in this area are strongly recommended.
Karina Perez (karina.perez.delgadillo@mx.pwc.com), PwC, Mexico
