Understanding the business purpose test in the Mexican tax system
Jorge Díaz Carvajal of Escalante & Asociados explains why taxpayers should comply with the business purpose provisions in Mexico’s Federal Tax Code.
As part of the global trends to try to reduce aggressive tax schemes, in recent years the OECD has suggested adopting the business purpose test as a general anti-abuse rule.
In domestic legislation, the business purpose test (Article 5-A of the Federal Tax Code 2020) is a tool against tax avoidance that allows tax authorities to disregard artificial transactions that do not serve a business purpose when taxpayers obtain a tax benefit that is superior to the reasonably expected economic benefit (’economic benefit’).
On the one hand a tax benefit is identified as the reduction, elimination, or deferral of a contribution, on the other hand a reasonably expected economic benefit exists when the transactions of a taxpayer intend to generate income, reduce costs, increase value of assets, improve market positioning, among others.
Specifically, although Article 5-A of the Federal Tax Code was introduced for the first time in 2020, its scope was broadened with the amendments made to the Federal Tax Code and to the Income Tax Law, in force as of 2022, which included the business purpose test as a mandatory requirement for:
Mergers and spin-offs not to be considered as an alienation of assets;
Corporate restructuring authorisations to be considered valid; and
Avoiding the application of back-to-back loans treatment to financing between related parties.
The consequence of not passing the business purpose test, as provided for by Mexican tax laws, is that transactions may be ‘recharacterised’ modifying accordingly the tax effects already given, when (i) the economic benefit is inferior to the tax benefit; and (ii) the economic benefit could have been achieved with fewer legal acts and their tax effects would have been more burdensome.
In general, the recharacterisation may be presumed (rebuttable presumption) considering facts, circumstances, elements, and documentation from the taxpayer and (as it is envisioned so far) to formally recharacterise the acts it is required a positive opinion issued by a governmental collegiate body (so far not integrated).
A. Mergers and spin-offs lacking a business reason may be deemed as alienation of assets, triggering the corresponding income tax (IT) and value added tax (VAT) and it may be inferred from the ‘relevant transactions‘ carried out within five years prior to and after the merger or spin-off.
Relevant transactions, as specified in the corresponding tax provisions, include the transfer of shares, voting rights or business segments of the merging, spinning-off or spun-off entities.
B. Restructuring authorisations for transferring shares at a tax cost within the same group may be revoked, as well as in the case of restructuring authorisations filed for purposes of deferring the IT triggered due to the transfer of shares.
This implies that the compliance of requirements for obtaining authorisations regarding restructurings (in connection to shares owned by Mexican tax resident entities or shares owned by tax residents abroad) is tightened and consequently a payable IT may be determined if the business purpose test is not passed in these cases.
Additionally, it is important to consider that with the amendments to the tax provisions described, the tax authority has more information at hand (to review the taxpayers) as an obligation exists for the later to inform about the relevant transactions carried out by them (either for transfer of shares or restructurings).
C. Financing transactions between related parties may be deemed as back-to-back loans, if the specific transaction lacks a business purpose with the correlative impossibility to deduct the payments made.
Based on what has been mentioned, it is of the upmost importance for taxpayers to comply as best as possible with business purpose provisions in Mexican legislation, otherwise, depending on the specific transaction at hand, it may:
Cause the recharacterisation of transactions, which could result in adjustments to the tax effects already taken;
Result in the payment of taxes (IT and/or VAT), regarding mergers and spin-offs;
Imply that the IT triggered due to the transfer of shares, related to a restructuring, should be paid (at a value according to the arm's-length principle); and
Result in the imposition of penalties, surcharges, and adjustments for inflation.
Moreover, as these provisions are yet to be enforced by Mexican tax authorities it is unknown how strict their position will be regarding the documentation and/or supporting information required to duly evidence the business purposes of transactions, as well as the position of the corresponding courts in case of litigation matters.
Although the business purpose test could already be applicable to any transaction, the amendments made to the tax provisions, as of 2022, indicate that is it more likely for it to be enforced, reviewed, and observed closely by the tax authorities regarding mergers and spin-offs, corporate restructurings, and financing transactions.