Mexico: The tax treatment of dividends paid to US residents
Francisco J Matus Bravo and Norberto Ruiz of Basham Ringe & Correa describe the tax treatment applicable in Mexico to dividends paid to US residents, based on income tax law and the US–Mexico tax treaty.
Prior to 2014, dividends paid out of profits on which a Mexican company had already paid the relevant corporate tax, were tax-free in Mexico. For this purpose, companies are entitled to create an ‘after-tax profits account’ or ’Cuenta de Utilidad Fiscal Neta’ (CUFIN).
Once the applicable corporate tax rate had been paid, any dividend or profit distribution was not subject to further taxation regardless of the nationality or residence of the recipient. In other words, dividends distributed to shareholders, regardless if they were national or foreign residents, were not taxed in the hands of the shareholder as long as the dividends came from the CUFIN account.
However, as of 2014, the Mexican Income Tax Law (MITL) was amended so that foreign residents pay a 10% tax on dividends paid to Mexican companies.
Under the MITL, corporate profits are taxed at the corporate level at the 30% rate in all cases. The CUFIN is increased by the amount the profits pay the relevant income tax and reduced when the profits are distributed to the shareholders.
Conversely, if the corporate tax is not paid at the time a dividend is distributed, then the corporation must pay the corresponding dividend tax. In these cases, the law provides that the income tax due must be added to the dividends or profits to be distributed.
The dividends must be multiplied by 1.4286 and the result thereof is subject to the 30% rate (this procedure allows the shareholders to receive the same amount of profits as originally declared by the distributing entity in spite of this tax). This results in an effective tax rate of 42.86% on the cash received by the shareholder. So in other words for distributing $100.00 to the shareholders, the company has to pay $42.86.
In this case, the taxpayer is the company paying the dividends not the shareholders so there is no alternative for treaty benefit.
Additional income tax for distribution of dividends
Articles 1 and 153 of the MITL sets forth that foreign residents with no permanent establishment in Mexico earning income from Mexican sources of wealth are required to pay income tax in Mexico.
Pursuant to Article 164 of the MITL, in the case of dividends distributed by Mexican entities, the source of wealth shall be considered to be located in Mexico when the entity that distributes them resides herein.
“Articles 1 and 153 of the MITL sets forth that foreign residents with no permanent establishment in Mexico earning income from Mexican sources of wealth are required to pay income tax in Mexico”.
Accordingly, Mexican entities distributing dividends to foreign residents should withhold 10% of the amount of the distributed amount. The withheld tax shall be considered definitive. This additional tax is different from the ‘corporate tax’ described above since the taxpayer is the foreign resident shareholder.
It is worth mentioning that this additional 10% tax applies only on dividends corresponding to profits earned as of January 1 2014. Therefore, legal entities distributing dividends, must have two CUFIN accounts, one for profits earned prior to January 1 2014 and one for profits earned afterwards.
Mexico–US tax treaty
Mexico has entered a tax treaty with the US (tax treaty), which may reduce the taxation on dividends described above.
Article 10 of the tax treaty sets forth that dividends paid by a company which is a resident of one of the states (Mexico) to a resident of the other state (US) may be taxed in that other state (US).
However, Article 10(2)(a) of the tax treaty sets forth that dividends may also be taxed in the contracting state of which the company paying the dividends is a resident (Mexico) and according to the laws of that state (Mexico).
Generally, under Article 10(2)(a), dividends are subject to tax at the 10% rate, but if the recipient is a resident of the other contracting state (US) and the beneficial owner of the dividends and holds directly at least 10% of the voting shares of the company paying the dividends, the tax so charged shall not exceed 5%, subject to complying the limitations on benefits set forth in Article 17 of the tax treaty.
Additionally, Article 10(3) of the tax treaty provides that dividends shall not be taxed in the contracting state of which the company paying the dividends is a resident (Mexico) if the beneficial owner is a resident of the other contracting state (US) and is, among other cases, a company that has owned shares representing 80% or more of the voting shares of the company paying the dividends for a 12-month period ending on the date the dividend is declared, and that:
Prior to October 1, 1998, owned, directly or indirectly, shares representing 80% or more of the voting stock of the company paying the dividends; or
Is entitled to the benefits of the tax treaty according to Article 17(1)(d)(i) or (ii), or 17(1)(g) of the tax treaty, which refers to the limitation on benefits clause of the treaty, which will be further addressed; or
Has received a determination from the relevant competent authority.
So, pursuant to Article 10 of the tax treaty, there are three alternatives:
As a general rule, dividends paid by Mexican entities to US residents shall be subject to tax in Mexico at 10% rate; however
If the beneficial owner of the dividends holds at least 10% of the voting shares of the company then the 5% tax rate applies; and
It would be exempt in Mexico if the beneficial owner of the dividends is a company owning at least 80% of the voting shares of the company distributing the dividend for at least a 12-month period ending on the date the dividend is declared, and any of the following is fulfilled:
Prior to October 1998 owned shares representing 80% or more of the voting stock of the company making the distribution;
Is entitled to the benefits of the Convention under Article 17(1)(d)(i) or (ii); or
Is entitled to benefits of the Convention under Article 17(1)(g); or
Receives a favourable ruling from the competent authority under Article 17(2) of the tax treaty.
Limitation on benefits
To apply the benefits of the tax treaty, it is not enough to be a resident of the contracting states, the requirements set forth on Article 17 of the tax treaty should also be met.
Based on the US Treasury Department Technical Explanations, Article 17 assures that source basis tax benefits granted by a contracting state pursuant to the convention are limited to the intended beneficiaries, that is, residents of the other contracting state who have a substantial presence in, or business nexus with, that state.
Article 17(1)(g) of the tax treaty establishes that a company is entitled to the benefits of the tax treaty with respect to dividends it receives when said company satisfies the following conditions:
More than 30% of the company’s shares is owned, directly or indirectly, by persons resident in a contracting state and entitled to the benefits of the tax treaty under subparagraphs a), b), d) or e) of Article 17(1), for example, individuals or a company in whose principal class of shares there is substantial and regular trading on a recognised securities exchange located in either of the contracting states;
More than 60% of the number of shares of each class of the company’s shares is owned, directly or indirectly, by persons resident in a state that is a party to NAFTA; and
Less than 70% of the gross income of the company is used directly or indirectly to meet liabilities (including liabilities for interest or royalties) to persons that are not entitled to the benefits of the tax treaty; and
Less than 40% of the gross income of the company is used directly or indirectly to meet liabilities (including liabilities for interest or royalties) to persons that are neither entitled to the benefits of the tax treaty nor residents of a state that is a party to NAFTA.
Even though Article 17(1) has many years in force, there are no judicial precedents in which its analysis or interpretation is addressed.
In practice, the tax authorities require, in addition to the residence certificate, evidence to prove each of the points referred to in Article 17 at the beginning of a tax audit.
Additionally, Article 4 of the MITL provides that tax treaty benefits to avoid double taxation only apply to taxpayers proving that they are residents of the relevant state and comply with the provisions of the tax treaty and the procedural provisions set forth in the MITL, among others.
Likewise, Article 4 establishes in its second paragraph that in cases of transactions between related parties, the tax authorities may request from the foreign resident proof of the existence of a double juridical taxation, through a statement under oath, signed by its legal representative, which must expressly describe that the items of income subject to taxation in Mexico and upon which the benefits of a tax treaty are intended to be applied, are also subject to tax in its country of residence.
Francisco J Matus Bravo
Basham Ringe & Correa
T: +52 55 5261 0400
Francisco J Matus Bravo is a partner at Basham Ringe & Correa.
Francisco’s practice focuses on tax planning, consulting, and strategy, both nationally and internationally, including advice for capital investment funds, foreign pension and retirement funds, corporate and individual taxation, due diligence, corporate reorganisations, mergers, spin-offs and acquisitions.
Francisco has two master’s degrees: first in tax law taxation and the second in finance law from the Universidad Panamericana. He is an active member of the International Fiscal Association (IFA) YIN, Asociacion Nacional de Abogados de Empresa (ANADE), among others.
Basham Ringe & Correa
T: +52 55 5261 0400
Norberto Ruiz is a senior associate at Basham Ringe & Correa.
Norberto’s practice focusses on tax controversy and tax litigation. He has managed audits, settlements and court cases for a broad spectrum of businesses and industries, such as mining, investment funds, pharmaceuticals, consumer products companies and in general, cross-border transactions.
Norberto holds a master’s degree in taxation (cum laude) from the Universidad Panamericana. He is a member of the Mexican Bar Association.