The tax authorities have sent the Congress a tax bill including proposed legislation concerning additional interest deductibility restriction to be effected through a series of thin capitalization rules that would enter into force on January 1 2005.
According to the proposed bill, the tax authorities consider that certain parties have made use of debt operations as a way to improperly reduce their income tax base or to transfer tax profits or losses from one company to another or to low-tax jurisdictions.
To discourage those mechanisms and to ensure companies operate with reasonable equity-to-debt margins from both the tax and financial viewpoints, the tax authorities are proposing to disallow interest charges to a Mexican company on financing in excess of a 2:1 debt-to-equity ratio.
According to the proposed thin capitalization rules, a taxpayer is considered to have excess debt on the basis of the fixed 2:1 ratio test, to the extent the amount of average debt of the taxpayer (including the debt granted by non-related parties) exceeds two times the equity amount for tax purposes. This fixed ratio test, in fact, works as a safe harbour rule.
For that purpose, equity means the sum of capital contributions recognized for tax purposes and the after-tax profits of the borrower, both duly restated for inflation.
Additionally, provisions are established that make it possible to increase the debt-to-capital ratio, when companies need financing for expansion and improvements to their facilities. However, those debts must be reduced proportionally to the annual depreciation of the acquired fixed assets.
Companies belonging to the financial system will not be subject to these thin capitalization rules, since they are governed by separate specific legislation.
Lastly, a number of questions remain unanswered such as whether the rules apply to currency exchange losses, which are classified as interest for Mexican income tax purposes. It is expected that the proposed changes may be amended to clarify the current open issues.
Roberto del Toro (roberto.del.toro@mx.pwc.com)
Carlos Orel Martinez (carlos.orel.martinez@mx.pwc.com)
