Mexico passed a new law establishing the single-rate business tax (IETU), in effect from 2008. This tax acts as an alternative minimum tax in lieu of the repealed asset tax, payable by taxpayers that do not have income taxes owed. The law disallows the deduction of interest and royalties paid to related parties and provides transfer pricing rules for related-party transactions. A decree providing IETU incentives for maquiladoras was also issued.

Transfer pricing requirements

Article 215 of the Mexican Income Tax Law (MITL) stipulates that taxpayers conducting transactions with related parties are obliged to determine their cumulative income and authorised deductions, considering the prices or amounts of consideration that would have been used with unrelated parties in comparable transactions.

Article 86, Section XII of the MITL indicates that taxpayers who carry out transactions with nonresident related parties must keep and maintain documentation proving that their taxable income and deductions were agreed at arm's-length.

There is no obligation in the MITL to file the transfer pricing documentation.

Article 86, Section XV establishes that companies that conduct related-party transactions, regardless of whether they are foreign or domestic, must comply with the arm's-length principle. Consequently, evidence of the transactions' compliance with the arm's-length standard must be shown through the application of one of the transfer pricing methods established in the regulations.

Article 215 of the MITL assumes that any transaction conducted with companies residing in low-tax regimes, as defined in the MITL, will be deemed to be between related companies at non-arm's-length values. The MITL further provides that the payments made to tax haven residents are not deductible, unless the taxpayer proves that the price or consideration was at arm's-length.

Article 86, Section XIII of the MITL establishes that companies that conduct transactions with related parties abroad must submit information on such transactions carried out during the preceding tax year when filing the statutory tax audit report. Amounts included in the informative return must match the information used in the TP documentation and the statutory tax report.

Taxpayers that in the year immediately preceding the current fiscal year earned income of less than Mex$13 million ($1.3 million) in business activities, or Mex$3 million in the performance of services, are released from the obligation to keep and maintain the transfer pricing documentation described in the MITL. However, they still have to file the informative return. Also, maquiladora companies are exempt from the obligation to file the informative return.

Maquiladora companies have different alternatives to comply with the MITL transfer pricing rules:

• to prepare and keep supporting documentation showing that their income and deductions in inter-company transactions are at arm's-length values plus 1% of the net value of machinery and equipment owned by the maquiladora's foreign related party;

• to generate a tax profit equal to the greater of 6.9% of the value of the assets used in their activity or 6.5% of the amount of ordinary costs and expenses of their operation; or

• to prepare and keep supporting documentation showing that income and deductions relating to inter-company transactions arising from its services are computed through the transactional net margin method, using the return on assets profit level indicator.

Maquiladoras can also request and obtain from the tax administration an advance transfer pricing agreement reflecting the profit that they should make.

The transfer pricing documentation must be prepared each year, no later than the filing date of the annual tax return (June). Regarding the transfer pricing tax return, it has to be filed no later than the date the statutory tax report is filed.

The arm's-length principle

Under Article 215 of the MITL, the taxpayer should consider the following elements to determine comparability:

• characteristics of goods and services;

• functional analysis, including assets used and risk taken in each type of transaction by every participant;

• contract terms;

• economic circumstances; and

• business strategies.

Effective since the 2002 tax year, the MITL specifies that the OECD transfer pricing guidelines may be used to interpret local transfer pricing obligations.

The six methods established in article 216 of the MITL are the same methods included in the OECD transfer pricing guidelines:

• comparable uncontrolled price;

• resale price;

• cost plus;

• profit split;

• residual profit split; and

• transactional net margin.

In 2006, the MITL introduced the best method rule by establishing a hierarchy for the application of transfer pricing methods. First and foremost is the comparable uncontrolled price (CUP) method. Only when the CUP is inappropriate may the taxpayer use the resale price (RP), cost plus (C plus), profit split (PS), residual profit split (RPS) or the transactional net margin method (TNMM).

When the RP, C plus or TNMM methods are applied, the methodology will be deemed appropriate when it is shown that the cost and selling price are arm's-length or when the taxpayer has obtained an advance pricing agreement (APA). The taxpayer must show that the method used is the most appropriate or most reliable method following all available information, giving primary preference to the RP or C plus method.

Article 216 of the MITL allows the use of a range of prices or profit margins resulting from the application of a method with two or more comparable transactions. In particular, the interquartile range is allowed.

The MITL establishes the possibility of applying reasonable adjustments to eliminate comparability differences among the comparable transactions or companies. Such adjustments must consider the following elements, depending on the type of transaction:

• product and service characteristics;

• functions, assets and risks involved;

• contract terms;

• economic circumstances; and

• business strategies.

A common practice of the Tax Administration Service (Servicio de Administración Tributaria- SAT) is to accept asset intensity adjustments such as differences in accounts payable, accounts receivable, inventories and fixed assets.

While there is no particular provision in the MITL that refers to the consideration of inflationary effects in the taxpayer's financial information for purposes of applying the transfer pricing methods, the SAT encourages the use of financial statements adjusted for inflation.

There is not enough financial information available for domestic companies. Therefore, Mexican tax authorities allow taxpayers to use international comparables. As a result, the taxpayer may hold that the use of foreign company data as comparables is acceptable in the absence of any other acceptable comparable data.

Under Article 69 of the Federal Tax Code (Código Fiscal de la Federación- FFC), the SAT may use confidential information obtained from third parties to determine the includible income and authorised deductions of taxpayers who have not conducted their transactions under the arm's-length principle.

Failure to comply with Articles 215 and 216 of the MITL may result in a tax audit with respect to transfer pricing. The SAT is empowered to determine the cumulative revenue or authorised deductions of taxpayers that have not carried out their related party transactions at arm's-length. This will result in a tax liability including the amount of unpaid tax as determined by tax authorities, the corresponding inflation, surcharges, applicable fines (50% to 100% of the omitted tax) and possible double taxation.

If the taxpayer does not have the supporting documentation referred to in Article 86, Section XII of the MITL, the authority may seek to modify deductions with respect to payments to nonresident related parties, under article 215 of the MITL.

The penalty for erroneously filing or not filing the informative return is a fine between $4,800 and $9,600 under the provisions of Section XVII of Articles 81 and 82 of the FFC.

Additional regulations

Article 34-A of the FFC provides that the tax authorities may issue APAs upon request. Bilateral APAs with countries with which Mexico has signed international tax treaties are also available.

Mexican tax authorities have issued the highest number of APAs in the region. Since their introduction, more than 1,388 APAs have been issued for maquiladoras. The experience of APAs for non-maquila companies is expanding. Maquilas' APAs are decreasing because Mexican Congress approved, at the beginning of 2003, some safe haven amendments to the taxation system for maquila companies (Article 216-Bis of the Income Tax Law). This gives more flexible compliance options to these companies without requiring them to follow an APA procedure.

Although there are no specific rules that disallow cost sharing agreements, the MITL contemplates several rules that could represent arguments for the SAT to reject the deductions derived from this structure. For example, the MITL explicitly rejects the deduction of foreign expenses calculated on a pro rata basis. However, from the perspective of Mexico's international tax agreements, such a structure would be allowed.

All payments made to foreign-related companies are subject to a specific withholding depending on the existence of a tax treaty or the direct application of the MITL.

Thin capitalisation rules are established in Article 32, Section XXVI of the MITL, which provides that any interest on debts with related parties, of more than three times its stockholders' equity, is nondeductible. Some exemptions and waivers regarding the thin capitalisation rules apply. For example, taxpayers that obtain an APA for inter-company loan transactions are not subject to this limitation. Last year the SAT authorised the first two thin capitalisation APAs, allowing a debt-to-capital ratio above the proportion allowed under the law. One of them was for an 8.7 ratio, the other for 7.4.

The MITL indicates that the following factors should be taken into account when analysing transfer pricing issues involving intangibles:

• type of transaction (licence or sale);

• type of property (patents, trade marks or technology);

• remaining useful life of the intangible asset; and

• level of protection.

The Mexican transfer pricing rules indicate that factors such as the nature of the services and required knowledge should be taken into account when analysing transfer pricing issues regarding services.

The MITL transfer pricing rules for inter-company financing focus on the characteristics to be taken into account to apply a correct comparability with transactions with unrelated parties. These characteristics include the principal amount, payment period, guarantees, debtor solvency and interest rate.

Payments of interest to foreign-related parties may be deemed dividends if they arise from an unconditional promise of payment agreement involving the total or partial payment of a credit received, standby credit or profit-bound payment condition, as well as the management of the business.

In the case of transactions related to sales or purchases of stock, the taxpayer must consider elements such as the value of the stockholder's equity of the issuer as of the transaction date, the present value of its profits or cash flows or the last published market price of its stock.

Audits

There is no public information regarding how the SAT programmes transfer pricing audits. However, the SAT may use the following documents, among others, to begin a transfer pricing audit:

• private ruling requests;

• statutory tax audit reports;

• annual tax returns;

• company websites; and

• customs information.

Mexico has conducted audit activities within numerous industry segments. In the past, tax authorities audited companies' offices. More recently, however, companies have been auditing their own offices. This is called gabinete audit or desk audit. When an audit is started, the tax authorities review all the related party transactions.

The typical transfer pricing issues raised by Mexican tax authorities are the arm's-length application, tangible property purchases and the incorrect selection of comparables or transfer pricing methods.

Article 213 of the Income Tax Law was amended to authorise the tax authorities, in or after 2008, to determine simulation for tax purposes without requiring a court finding of simulated acts. Therefore, the SAT may re-characterise transactions for tax purposes considering presumptive elements, but only for related-party transactions. The authority must provide appropriate grounds and reasoning for its actions, identifying the allegedly artificial act and quantifying it against the actual intent.

As of 2007, there have been 23 TP audits completed: 53 are still open.

The types of transactions being reviewed by the SAT are mainly the following:

• sales and/or purchases of tangible and intangible goods;

• services;

• reimbursements; and

• interest payments.

To date, an official report has not been issued with regard to the official position on transfer pricing audits. However, in our experience, the SAT will likely challenge the following tax strategies:

• migration of intangible assets;

• debt push-down;

• thin capitalisation;

• domestic transactions, particularly when a company is undergoing a restructuring or reports operating losses; and

• conversions from full manufacturer to contract manufacturer.

Taxpayers are advised to prepare their annual transfer pricing documentation before the end of the tax year. The focus of such documentation should be to demonstrate the economic substance of their inter-company transactions.

Also, it is important to check the consistency of the transfer pricing information submitted to the tax authorities in the different filings and documentation, such as the information return, the statutory tax report and the transfer pricing documentation.

The SAT will not agree on services based on a percentage of sales, and for pharmaceutical companies we recommend a review of generic active ingredients purchases, as the SAT states it has information from the General Customs Administration on prices used by independent laboratories for the same raw materials. They are imposing a large transfer pricing adjustment for these active ingredients.

Managing the audit process

The defence procedures a taxpayer could use to challenge a negative ruling by the SAT regarding transfer pricing include:

• administrative appeal;

• litigation appeal; and

• competent authority procedure.

Few transfer pricing cases proceed to litigation. However, we believe litigation activity will increase in the following years.

The administrative appeal procedure involves filing a protest before the SAT Appeals Office (Central Tax Counsel). The protest should contain arguments of form and/or substance. The appeal must be filed within 45 business days.

The litigation appeal procedure involves filing a petition before the Tax Court (the Federal Court for Tax and Administrative Justice). The suit must be filed within 45 business days

During December 2006, the Ministry of Finance published certain tax amnesty provisions in the Public Revenues Law for the fiscal year 2007. Also, along with the entry of the new government (Felipe Calderón) in 2007, a new tax amnesty programme was introduced. In general, the amnesty offered by the new government reduced taxpayer assessments by up to 80%, including 100% of penalties and surcharges.

This reduction, combined with the fact that the payment does not create a precedent for taxpayer acquiescence, led several companies to withdraw their court cases or administrative appeals, opting instead to pay the reduced amount available under the amnesty programme.

According to Article 217 of the MITL and all of the tax treaties signed by Mexico, the competent authority procedure is now required more often by taxpayers.

Figure 1
Australia	Ecuador	Japan	Russia
Austria	Finland	Korea	Singapore
Belgium	France	Luxembourg	Slovakia
Brazil	Germany	Netherlands	Spain
Canada	Greece	New Zealand	Sweden
Chile	Indonesia	Norway	Switzerland
China	Ireland	Poland	UK
Czech Rep.	Israel	Portugal	US
Denmark	Italy	Romania

Mexico has entered into double taxation treaties with countries listed in figure 1.

The majority of the treaties signed by Mexico contemplate the possibility of applying a corresponding adjustment.

Article 217 of the MITL allows Mexican taxpayers to file an amended complementary annual tax return following a transfer pricing adjustment with countries with which Mexico has signed international tax treaties to avoid double taxation. However, such an adjustment should previously be approved by the SAT.

At the moment, arbitration procedures are rarely used to resolve transfer price cases; there are only some tax treaties that include arbitration. No additional administrative routes to settle transfer pricing disputes, or any other income tax disputes, have been provided under Mexican tax law.

While there is no official information regarding the number of transfer pricing cases in court, it is estimated that, as of July 2007, there are between three and five such cases in the automotive, pharmaceutical, maquiladora end electronics industries for debt push-down strategies.

Trends and perspectives

We expect an increase in audit activity, the determination of permanent establishments and the imposition of fines which will encourage some taxpayers to pay and drive others to the tax court.

There are no official reports from the tax authorities in regard to trends and perspectives related to transfer pricing. However, in various unofficial public forums representing the SAT, it was expressed that the SAT would propose to congress an amendment to the MITL in order to:

• clarify the obligation to document domestic inter-company transactions according to the same requirements of the foreign transactions;

• extend the deadlines for having transfer pricing documentation and filing the corresponding information return; and

• propose a de minimis rule to disregard from transfer pricing documentation transactions that are not economically relevant.

Tax audits will probably increase in the near future and will focus on more sophisticated transactions such as royalty payments, financial valuations and intangible assets.

Moisés Curiel
		Baker & McKenzie in Mexico Tel: +52 55 5279 2992 Email: moises.curiel@bakernet.com Moisés Curiel is the Latin American transfer pricing director for Mexico and Latin America at Baker & McKenzie. He earned his bachelor's degree in public accountancy from the Instituto de Estudios Contables, with a specialisation in tax from the Universidad Panamericana and a specialisation in intellectual property from the Instituto Tecnológico Autónomo de México. He carried out the first transfer pricing audits in Mexico, which could be considered as the first in Latin America. Moisés participated in the drafting and implementation of various transfer pricing rules in the Mexican Income Tax Law, the Miscellaneous Resolution and the Federal Fiscal Code. He was a representative member of the Mexican Government in the transfer pricing working group of the OECD. He is a member of the Mexican College of Public Accountants and of the Mexican Institute of Public Accountants. He has given courses in international tax at the Universidad Nacional Autónoma de México (UNAM), in the Escuela Bancaria y Comercial and at the Instituto Superior de Estudios Contables.

Carlos Linares
		Baker & McKenzie in Mexico Tel: +52 81 8399 1371 Email: carlos.linares-garcia@bakernet.com Carlos Linares is a national partner at Baker & McKenzie in Mexico. He earned his bachelor's degree in economics from the Universidad Autónoma de Nuevo León (UANL) and holds a MA and a PhD in economics from Rice University in Houston Texas. Linares obtained a diploma in international tax from Harvard University and the Instituto Tecnológico Autónomo de México (ITAM). He is a professor of economics and public finance at the UANL and Tecnológico de Monterrey. His experience includes working as a deputy director in the international tax area of the Mexican Ministry of Finance (Hacienda).

Emilio Angeles
		Baker & McKenzie in Mexico Tel: +52 55 5351 4148 Email: emilio.angeles-acosta@bakernet.com Emilio Angeles is a national partner at Baker & McKenzie in Mexico. He is a certified public accountant, graduated from the Escuela Bancaria y Comercial and has a master's in economic and financial engineering from La Salle University. He has taken several courses in international treaties for avoiding double taxation and in transfer pricing. He has worked for more than 13 years in the tax arena, nine of which have been in international tax, particularly in transfer pricing. He has worked in various prestigious public accounting firms and was head of the department of transfer pricing and Title V in Income Policy in the Ministry of Finance and Public Credit from 1993 to 1996. He is a member of the Mexican National Board of the Maquiladora Exportation Industry. In addition, he has been a professor of international trade at various universities at a postgraduate level.