Mexican back-to-back loans may be recharacterised as dividends for tax purposes
Ángel Escalante Carpio, Juan Manuel Morán and Gabriel Rojas Izquierdo of Escalante & Asociados discuss the impact of recharacterising interest from certain loans as dividends.
One of the main tax planning schemes that has been fought internationally in recent years is the excessive deduction of interest as a means to erode the taxable base in high-tax jurisdictions and avoid the taxation of dividends.
On that regard, through Action 4 of BEPS, the OECD recommended the design of rules to prevent tax base erosion and profit shifting through excessive interest deductibility.
As a result, through the 2020 reform Mexico incorporated a general anti-abuse rule (GAAR), adding Article 5-A to the Federal Tax Code (FTC), which is intended to combat legal acts that lack a business reason and generate tax benefits.
In addition, Mexico has several special anti-abuse rules (SAAR), including thin capitalisation rules and the limitation on interest deduction in excess of a certain percentage of a sort of tax earnings before interest, taxes, depreciation and amortisation (EBITDA) are noteworthy.
In income tax matters, there are several cases in which the interest arising from certain loans, including back-to-back loans, must be recharacterised as dividends for tax purposes, as an SAAR.
An example of this would be Section V of Article 11 of the Income Tax Law (ITL), establishing that in case of interest derived from loans granted to legal entities or permanent establishments in the country of residents abroad, by people residing in Mexico or abroad who are related parties of the loan payer, shall be deemed as dividends for tax purposes when such interest arise from back-to-back loans, even when granted through a financial institution residing in Mexico or abroad.
Also considered as backed loans are those transactions in which a person grants financing and the loan is secured by cash, cash deposits, shares, or debt instruments of any kind, of a related party or of the borrower itself.
In line with the above, through the 2022 tax reform, a last paragraph was added to Section V of Article 11 of the ITL, which provides that financial transactions, other than those already contemplated, will be treated as backed loans when they lack a business purpose and interest is earned by legal entities or permanent establishments in Mexico of foreign residents.
Considering the above, there are a few aspects of the reform that we must bring to your attention:
This new rule is particularly broad, and may include operations that are foreign to the original purpose of the SAAR, without admitting any evidence to the contrary, which we consider would not pass the proportionality constitutional test;
The main effect for the taxpayers is the impossibility to deduct interests which will be recharacterised as dividends, even when the corresponding operation complies with transfer pricing rules and other anti-abuse dispositions, which in practice implies a limitation to the licit activities that they can carry out and the source of their funding; and
The relevance to prepare a defense file to demonstrate the business reasons of any loan involving transactions between Mexican and foreign tax residents.
In our opinion, Article 11 of the Income Tax Law, including its latest amendment, is anachronistic and has had largely superseded, since its purpose can be achieved through the correct application of GAAR and SAAR that were previously in effect in the ITL.
The main impacts of recharacterising interests as dividends are (i) such payments shall not be deductible for its payer; and (ii) the withholding applicable to dividends, which will depend on the identity of the subject receiving the income.
Ángel Escalante Carpio
Founding partner, Escalante & Asociados
Juan Manuel Morán
Senior associate, Escalante & Asociados
Gabriel Rojas Izquierdo
Junior associate, Escalante & Asociados