The reinforcement of the controversial concept of business reason in the 2022 tax reform in Mexico could result in the disallowance of deductions or the loss of tax benefits.
A general anti-avoidance rule was included in Mexican legislation two years earlier, which is contained in Article 5-A of the Federal Tax Code (FTC). This norm has two main points to consider:
Whether the legal acts lack a business reason; and
Whether they generate a direct or indirect tax benefit.
However, the provision has generated a number of controversies, because it allows the tax authorities, in the exercise of their assessment and auditing powers, to presume that there is no business reason when the reasonably expected quantifiable economic benefit is less than the tax benefit.
Definition problems
Still, the legislation does not define or conceptualise what is to be understood as a business reason. There are precedents, such as thesis VIII-P-1aS-217 issued by the First Section of the Superior Chamber of the Federal Court of Administrative Justice, in the session of August 15 2017. The thesis states that "in financial jargon, it is understood as the motive to perform an act, to which one is entitled, related to a lucrative occupation and aimed at obtaining a profit; that is to say, it is the reason for the existence of any lucrative company that implies seeking extraordinary profits that benefit the shareholder and foster the generation of value, creation, and development of long-term relationships with customers and suppliers".
However, the result will not be applicable in all cases, because there are operations that will not necessarily generate an extraordinary profit, due to their nature or complexity. Similarly, a "reasonably" expected economic benefit is determined by a subjective interpretation by the tax authorities.
Despite the lack of definitions mentioned above, the concept of business reason has been reinforced in the tax reform of 2022. For example, in Article 11 of the Mexican Income Tax Law (MITL), a fifth paragraph was added to Section V to indicate that interest derived from financing operations known as back-to-back loans will have the tax treatment of dividends and a corresponding tax payment. Similarly, the business reason was included as a requirement to maintain the tax benefits in corporate restructuring matters such as the disposal at tax cost referred to in Article 24 of the MITL, restructurings due to the alienation of shares carried out by foreigners under Article 161 of the same law, and mergers and spin-offs referred to in Article 14-B of the FTC.
If the tax authority – in the exercise of its assessment and auditing powers – presumes that a restructuring transaction lacks a business reason, there will be higher tax, and there may even be effects on relevant transactions entered into previously.
Another assumption is that the business reason was included as an additional requirement for some deductions. For example, on the subject of interest deduction, of thin capitalisation (imbalance of the relation between a minimum capital and a debt excessive) referred to in Section XXVII of Article 28 of the MITL, which establishes an optional procedure that cannot be exercised unless it is demonstrated before the tax authorities that the transactions carried out have a business reason.
Challenges for taxpayers
The business reason is clearly an aspect that has some uncertainties but its importance has been strengthened in the 2022 tax reform. Hence, the tax authorities will review it in detail in the exercise of their duties.
It is therefore of vital importance that in the aforementioned cases there is adequate documentary evidence – in the event that the tax authorities exercise their assessment and auditing powers – that the transaction carried out is related to the corporate purpose of the company; that it is aimed at obtaining or increasing profit, or at the realisation of an economic value; and that there is a formal agreement or contract specifying the rights and obligations corresponding to each of the parties, in addition to including the material elements of each transaction.
The foregoing conditions apply regardless of compliance with the other formal requirements established by the tax provisions. These include strict indispensability, and that transactions between related parties must be documented in a manner that shows that the transactions were agreed as if they had been made between independent third parties and that they were within the ranges indicated in the transfer pricing analysis. Similarly, the transactions should be supported by suitable contractual vehicles and the distribution of risks should effectively correspond to the functions performed.
All these factors represent a new challenge for Mexican taxpayers.
