What Mexican tax reform means for foreign investors
The Mexican government, under the leadership of President Andrés Manuel López Obrador (AMLO), approved the first major tax reform of its administration, which will take effect on January 1 2020.
The tax reform package includes some key parts of the BEPS action points. Some of the newly incorporated regulations in Mexico, among others, are: neutralising the effects of hybrid mismatch arrangements (Action 2); limitation on interest deductions (Action 4); harmful tax practices (Action 5); prevention of tax treaty abuse (Action 6); and mandatory disclosure rules (Action 12).
However, there are two key issues for foreign business leaders who are looking to invest in Mexico, including:
Foreign residents participating in private equity funds that invest in Mexico; and,
Legal acts in which there is a tax benefit and disclosure of transactions by tax advisors.
These reforms may bring Mexico closer in line with OECD standards, but the implications are worth examining.
Foreign residents participating in private equity funds that include Mexican companies
The private capital market in Mexico has grown significantly in recent years, with investors that are mainly international organisations, foreign banks, international funds, and others who have had particular interest in investing in Mexico's financial services, infrastructure, energy, and healthcare sectors, among others.
Depending on the characteristics of the investors, the projects themselves, and the investment agreements, managers have structured the funds with private vehicles, such as limited liability companies (LLCs) from the US, Mexican fideicomisos, and limited partnerships from some provinces of Canada, among others.
The US LLCs have been commonly used vehicles when the investors that participate in the entities are residents, for tax purposes, in the US, because according to the case and the type of income, the expected benefits could be covered, under the tax treaty between Mexico and the US, through the mutual agreement procedure (MAP).
For some projects, limited partnerships are ideal vehicles for the political and legal stability in Canada, the flexibility to reach investment agreements with partners, and, in fiscal matters, because they are vehicles that in Mexico have been treated as transparent for tax purposes. That is, during an event of liquidity of the funds, such as a sale of shares or a dividend, it is the members themselves of the fund who are obliged to recognise the tax effects that derive from the income as if they had generated them directly.
The tax transparency treatment has been granted in Mexico to some vehicles since the end of the 1990s through particular rulings approved by the Mexican tax authority. Subsequently, and due to the growth of the sector, a few years later the tax authority incorporated a rule to grant such transparency to vehicles such as limited partnerships, provided that, among other things, they were created in a country with which Mexico had entered into a tax information exchange agreement.
Regarding this, in the tax reform for 2020, Article 205 was added in order to maintain the transparency tax regime for foreign legal figures that manage private capital investments in legal entities residents in Mexico – only for interests, dividends, capital gains, and lease of real estate – and subject to compliance with specific requirements.
The requirements are the following:
i) The manager of the fund or its legal representative in Mexico, file before the tax authorities a record of all the members of the figure in each year, including the documentation proving the tax residence of each member;
ii) The fund has been set up in a country or jurisdiction with which Mexico has a tax information exchange agreement;
iii) The members of the fund, including the manager, reside in a country or jurisdiction with which Mexico has a tax information exchange agreement;
iv) The members of the fund, including the manager, should be the effective beneficiaries of the income received by the fund;
v) The income attributable to members who are resident abroad should be effectively recognised as taxable by them; and
vi) The income obtained by the members residing in Mexico should be recognised as taxable in accordance with the applicable tax provisions.
In case that any of the requirements indicated above in points i, iii, iv, v and vi, are not met, the fund will not enjoy fiscal transparency in the proportion of the member for which the requirement could not be met. For example, if a member of a fund resides in a country in which Mexico does not have in force a tax information exchange agreement, in a sale of shares the buyer, if it is Mexican resident, shall withhold 25% income tax over the price of the transaction without any deduction, on the proportion of the participation of such member.
Similarly, in the case that for some reason it fails to comply with 100% of the requirements, or if a fund such as these decides not to apply Article 205 (as described above), the fund must pay income tax in Mexico and withholding rules applicable to foreign residents may be applicable to the fund.
However, although it appears that during the following years tax transparency will continue for these types of funds (limited partnerships of some provinces of Canada), the new requirements of article 205 may represent challenges for some funds.
Finally, it is important to take into consideration that in case that a fund has established their main business administration or effective management headquarters in Mexico, the fund will be considered as a Mexican entity.
Since this new article will be in force beginning 2021, the managers of the funds will have one year to analyze the rules that will be published by the Mexican tax authorities, and/or, if applicable, make adjustment in their funds.
Legal acts in which there are tax benefits and transactions disclosable by tax advisors
Based on the agreements reached with the OECD in terms of BEPS, several countries have included in their domestic regulations general anti-abuse rules to prevent the erosion of the tax base. European countries such as the Netherlands, Belgium, Spain, and others have included concepts such as "substance" or "business reason" to avoid the practice of certain transactions.
Related to this, as part of the tax reform that will come into effect from 2020, the Mexican government added a rule to prevent transactions that do not have a business reason and that through these operations tax benefits are obtained.
Legal acts that lack business reasons and generate a direct or indirect tax benefit will have the tax effects that correspond to those that had been made to obtain the economic benefit expected by the taxpayer.
The tax authorities may presume, unless proven otherwise, that there is no business reason, when:
i) The reasonably expected quantifiable economic benefit (REQEB) is less than the tax benefit; or
ii) A series of legal acts has no business reason when the REQEB could be achieved through a smaller number of legal acts and the tax effects would have been higher.
For these purposes, the following shall be understood as the tax benefit and REQEB:
i) Tax benefit relates to any reduction, elimination, or temporary deferral of a tax, through deductions, non-subjection to regulations, not recognising gains or income, adjustments or absence of the taxable base, and tax accreditation, among others; and
ii) REQEB related to taxpayer transactions that seek to generate income, reduce costs, increase the value of goods, and improve market positioning, among others.
The tax authorities may only exercise this authority during the audit process initiated to a taxpayer, through a specialised area of the Ministry of Finance and Public Credit.
Although the tax authorities do allow a tax benefit to exist in any legal act, the tax benefit should not be the main objective to carry out a legal act.
For example, currently there are corporate acts that by themselves do not have a quantifiable economic benefit because some are legal acts that must be carried out under another regulation, which is not tax-related.
There are also occasions in which, in order to carry out a transaction with a third party, such as a merger, it is necessary to implement prior legal acts, which do not follow a tax benefit, although some of such acts could trigger one.
These cases, and many other assumptions should be carefully reviewed in detail by internal accountants, lawyers and by taxpayers' own tax advisors.
In addition to the above, and in order to avoid abuses in tax matters, the obligation for tax advisors to disclose schemes that come from their advice and generates a tax benefit in Mexico was added to the Federal Tax Code.
A disclosable scheme is considered as one that generates or can generate, directly or indirectly, the obtaining of a tax benefit in Mexico.
There is a specific list of disclosable schemes, including the following:
i) Schemes where the exchange of information between countries is avoided;
ii) Where intangibles or tax losses are transmitted to a person other than who originally had them;
iii) Where transactions between related parties are carried out and there is no compensation in between;
iv) Involves a foreign resident who applies a double taxation treaty signed by Mexico, with respect to income that is not taxed in the country or jurisdiction of tax residence of the taxpayer;
v) Avoids identification of the beneficial owner of income or assets, through the use of foreign entities or legal figures whose beneficiaries are not designated or identified at the time of incorporation or at any time thereafter;
vi) Avoids generating a permanent establishment in Mexico in terms of the Mexican Income Tax Law and the double taxation treaties signed by Mexico.
It is clear that most of the listed schemes are clearly made to have a tax benefit, however the wording of some of them does not give full certainty for some legal and real transactions.
As a general rule, the schemes must be disclosed by the tax advisors who designed the scheme. There are some cases in which the obligation to report may fall on the taxpayer. For example:
i) If the scheme was designed and implemented by personnel of the taxpayer;
ii) If the scheme was designed by a tax advisor residing abroad; or,
iii) In the case that the tax advisor and the taxpayer agree that the scheme will be disclosed by the taxpayer.
Custom reportable schemes must be disclosed no later than 30 days after the day when the scheme is available to the taxpayer for implementation, or the first legal act is carried out, whichever comes first.
It is established that the reporting obligation will begin in 2020, but the deadlines for reporting will begin in 2021. As such, all reportable 2020 operations must be reported no later than January 30 2021.
These new rules will improve the way in which certain transactions are usually made, which may depend on a deeper analysis by the tax advisors based on economic reasons instead of a tax benefit, and of course expecting that the Mexican tax authorities use this authority in a reasonable manner to benefit the development of the country.
Antonio’s main practices areas include merger and acquisitions processes, corporate restructuring and private equity funds.
Antonio has counseled national and foreign funds during their investment processes, including structuring the fund, investment analysis (due diligence), operation and project exiting. He has also advised investors participating on the energy, infrastructure and agriculture sectors in Mexico, on brownfield and greenfield stages.
Antonio is part of the BMV faculty at Escuela Bolsa Mexicana – Mexican Stock Exchange, in which he teaches courses on tax matters related to IPO processes, Fibras (Mexican REITS), Fibra E (Mexican MLPs), ETFs, among others. He has frequent participations as speaker in multiple forums.
Currently, he acts as managing partner of VCG Partners, which was awarded by International Tax Review in 2018 as Best Newcomer in the Americas and in 2019 as Americas Tax Pro Bono Firm of the Year.
Alfonso Corral M
Alfonso Corral has experience advising companies as well as private and public funds during investment processes, corporate restructurings, purchase and sale of shares and disposal of assets.
He is involved in structuring projects in the energy, infrastructure and microfinance sectors in Mexico, where he provides continuous support regarding the Mexican tax implications that would arise derived from these types of transactions.
Alfonso keeps up to date by participating as a speaker in different courses and forums on tax matters, and by attending to conferences held by the American Chamber of Commerce of Mexico (AmCham), an association of which he is a member.
Héctor Trigos P
Hector Trigos has experience in projects focused on the energy sector in Mexico and abroad. He participates in tax consulting projects, drafting of opinions on tax matters, tax due diligence, as well as in the filing of proceedings before the Mexican tax authorities.
Hector is a member of the College of Public Accountants in Mexico.