Leveraged recapitalisations in Mexico
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Leveraged recapitalisations in Mexico

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Mexico’s economy has made notable gains in the past decade, bringing opportunities for financially healthy Mexican corporations to exploit leveraged recapitalisations. Galicia Abogados’ Federico Scheffler and Sebastián Ayza discuss the tax implications and impact for mergers and acquisitions (M&A).

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 Mexico.

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 go public.

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 recapitalisation schemes.

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 law.

For the sake of argument, we will refer to leveraged recapitalisations as leveraged recaps.

Financial flexibility

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 the proceeds.

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 non-resident.

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 tax rate.

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 exemption thereto.

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.

Share buybacks

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 of repurchase.

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.

Capital redemptions

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 account.

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 of 30%.

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 exist.

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.

Federico Scheffler


Tax partner

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 2018.

Sebastián Ayza


Tax associate

Galicia Abogados

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 transactions.

Sebastián worked from 2013 to 2018 in SMPS Legal in the transactional tax and tax litigation practice areas.

Sebastián studied law at Instituto Tecnológico Autónomo de México (ITAM).

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