Facing the tightening of the screws on TP documentation in Mexico
Jesús Aldrin Rojas of QCG Transfer Pricing Practice describes the transfer pricing documentation protocol in Mexico and explains why taxpayers should review their documentation practices.
The transfer pricing (TP) regime in Mexico is not new, it is about to be 25 years old.
Since its introduction in 1997, taxpayers have been required to obtain supporting documentation to demonstrate that they can prove that "the prices and amounts of consideration are agreed upon as independent third parties would do in comparable transactions". That is, based on the arm's-length principle established in Article 9 of the OECD Model Tax Convention.
To demonstrate that inter-company transactions do indeed adhere to the arm's-length principle, it is necessary to follow a documentation ‘protocol’. This protocol requires that for each operation carried out, the following must be reported:
The characteristics of the transaction;
Functions, assets, and risks;
Economic circumstances; and
These elements make it possible to ‘portray’ the attributes of the analysed transaction (e.g. purchases, services, royalties) in order to allow the construction of a reference parameter through which it is possible to prove that the negotiation dynamics that would have been considered by independent third parties were indeed reflected.
It should be emphasised that the documentation standard proposed by the Mexican Income Tax Law – LISR was modified by the OECD Action Plan v. the BEPS plan in its Actions 8–10 and 13.
These actions require additional considerations on issues such as risk distribution and the economic capacity to face them, services, intangible assets, and financial operations, to name a few (Actions 8-10, alignment of transfer pricing with value creation).
Of course, it is worth mentioning the restructuring of documentation practices that went from ‘stand-alone’ local analysis to obtaining documentation at three levels for a certain group of taxpayers (CbC, master file, local file), in line with Action 13 of the BEPS plan.
Despite this, the interpretation of the arm's-length standard differs widely throughout the country, and in many cases the supporting documentation does not meet the necessary elements either in depth or in form.
In response, the tax authorities have been providing clarifications via regulatory criteria, non-binding criteria, miscellaneous resolutions and even through answers to frequently asked questions on the SAT website.
Guidelines have thus been established as to the identification of unique and valuable contributions in the form of intangibles to the multinational group's business, modifications of values within the interquartile range, transfer pricing adjustments (corrections to the accumulated income or authorised deductions) and clarifications on the formulae related to comparability adjustments.
Against this background, the tax reform proposal for fiscal year 2022 makes important clarifications in terms of documentation. The first of these has to do with the way in which the inter-company operation is ‘portrayed’ (both national and foreign), requiring the analysis of functions, assets and risks to consider the contribution of all parties involved in the operation, not only of the entity under analysis.
This, of course, is intended to discourage the inappropriate use of the transactional operating profit margin method, and to give greater emphasis to profit sharing methods. Another relevant change relates to the period under review.
In Mexico, the use of averages (whether simple or weighted, regularly over a three-year period) is widely used to compare the profit, gross or operating margin obtained by the taxpayer with that of the comparables. The reform proposal limits this practice to cases in which the taxpayer's results are affected by business cycles in their industries and then it is not possible to capture the profitability of the transaction in a single fiscal year.
Regarding the use of methods based on profitability analysis (resale price methods, cost plus and transactional net margin method), the reform proposal requires the taxpayer to disclose the adjustment formulas used to eliminate differences between the analysed entity and the proposed comparables. The results obtained by the taxpayer should be shown in an interquartile range, as a preponderant measure for the analysis of the arm's length condition of an operation.
Finally, it will be necessary to consider the date when the documentation should be ready, May 15 for the local file (still an early date, considering that by that time not all the information from the public companies used as a reference is available) and the submission of the master and country-by-country report is left until December 31.
The changes explained above should lead taxpayers to a review of their documentation practices, prioritising the confirmation of the economic substance of the transactions and the alignment with the standard required by the LISR according to the proposed tax reform.
The ‘mechanical’ execution of the transaction without proper analysis should be a cause for alert because it may generate in taxpayers the false impression of complying with the regime by leaving loose ends that can subsequently lead to costly sanctions that can go as far as the loss of the deduction of inter-company expenses and consequently the recalculation of the taxable base, with the serious implications that this entails.
Jesús Aldrin Rojas
Managing partner, QCG Transfer Pricing Practice