Impact of changes to interest rates and country risk rates in Mexico
Enrique González and Ricardo Barbieri of EY Mexico consider the impact of changes to interest rates and country risk rates on the transfer pricing analysis of financial instruments.
The Mexican transfer pricing (TP) regulations require that any financial instrument that generates an attributable income or deductible expense as a consequence of a transaction between related parties, be analysed under the TP regulations established in the Mexican Income Tax Law (MITL) to demonstrate that it meets the arm’s-length nature.
As mentioned in the MITL, TP analyses should consider the variables of the financial instruments, for example: the amount and term of the transaction, the credit risk rating of the debtor, guarantees of the loan and the compensation (i.e. interest rate).
Independently, Article 179 of the MITL does not state that other variables should be considered, so there is a need to take other factors into attention for the characterisation of the loan and a reliable TP analysis, for example: the type of financial instrument, prepayment or convertible clauses and country residence of the debtor, among other aspects.
The MITL requires a functional analysis, the contractual terms of the intercompany transaction, the economic circumstances as well the business strategies and the reason behind the financial instrument, for example in case of granting a loan.
As the COVID-19 pandemic started in March 2020 and global economic growth was pushed on a downward trend, monetary policy and, thus, interest rates were adjusted downwards by most central banks to push the reactivation of the local economies.
COVID-19: Impact on Mexico
In Mexico, prior to the start of COVID-19, the Tasa de Interés Interbancaria de Equilibrio or TIIE (the Mexican interest rate usually used as reference for the loans in Mexican pesos) had levels between 7% and 8%, but has decreased to levels between 4% and 5% in mid-2021.
Other factors that have an impact in a TP analysis is the country risk, a variable that reflects a spread for financial instruments of the country where the debtor is located over the country reference interest rate.
The country risk for Mexico has increased during the Pandemic, and depending on the database used in the analysis the value may differ. For example, the ‘JP Morgan country risk index’ had levels of 3.6% of the country risk starting 2021 for Mexico, although ‘Ambito’ had country risk levels for Mexico of 2.1%. The difference usually depends on the variables considered by the analysts in the different sourcing companies.
Where comparable financial instruments may not be available in the same currency as the financial transaction under review, it may be required to perform an economic adjustment for currency differences.
An alternative to make this adjustment could be the International Fisher Effect for interest rates, where the expected nominal interest rate is equal to the real interest rate plus the expected inflation rate. Since the inflation rate in Mexico has fluctuated during the pandemic to values as low as 2% and as high of 5%, it may be relevant to consider a longer term of observations when using the inflation rate.
In addition to the complexities mentioned above, there may be a challenge in TP analyses in supporting historic rather than the forecasted observations or vice versa. In financial transactions, future expectations of an economy play a relevant role in compensations, which may not be included in historical information. This is also a challenge when using swaps to adjust the rates.
Due to COVID-19, the projections and forecast in the country risk, inflation and other variables in the economic environment is at some point uncertain as nobody had in its forecast the COVID-19 pandemic.
Therefore, one of the main challenges in the financial instruments TP analysis is the complexity of applying the different adjustments to the economic variables in order to estimate an arm’s-length range for proving that the income or deduction complies with the market values.
Finding the data and relevant information to be considered in a TP analysis to adjust the relevant characteristics of the financial instruments and adjust those is crucial for this type of analysis. So, it is important to document the economic analysis and emphasise in a good TP support the qualitative and quantitative arguments that support it.
Enrique González Cruz