Shareholder loans in Mexico – are they viable from a tax perspective?
Santiago Llano Zapatero and Diego Guerrero Segura of Ritch Mueller explain everything investors need to know when pursuing shareholder loans, and other sources of funding, in Mexico.
Whenever non-Mexican investors participate in a Mexican business, a few questions tend to crop up. These include: under which legal mechanism can the funds be transferred to the target companies? And: what could be the potential consequences for both the target company and the investors depending on the legal mechanism chosen?
From a corporate standpoint, investors have three options to fund Mexican companies. The first is via shareholder loans, which entails borrowing funds that must be repaid at a certain level of interest at a specific term. Then there is equity financing, which consists of granting a participation in the risks and profits of the company. Finally, there are contributions for future capital increases (AFACs), which are sums obtained by a company that can be converted into equity at a later date.
Depending on the investment structure implemented, the internal rate of return of the target companies and the investors may vary significantly since each entity’s legal, tax and accounting characteristics are different.
Characteristics of shareholder loans
They can be fixed in a different currency than Mexican pesos;
They are subject to inflation adjustments and FX gains and losses for tax purposes if not in Mexican pesos;
Interest payments may be deductible if all requirements in Mexican tax laws are met;
If interest is paid to a foreign company, a withholding tax ranging between 4.9% and 35% applies;
Principal payments are not subject to withholding taxes; and
No tax or accounting restrictions for payments apply.
Characteristics of equity financing
It must be supported in shareholder's meetings minutes;
It must be fixed in Mexican pesos;
It is not subject to inflation adjustment (except for the calculation of the capital contribution account) and is not subject to FX gains and losses for tax purposes;
Dividend payments (which only may be carried out if retained earnings for accounting purposes exist) are not deductible and if paid to a foreign company a 10% withholding tax applies; and
Tax and accounting rules for cash repatriation through either capital redemptions or dividend payments apply. The latter rules may trigger trapped cash issues in the Mexican company or the anticipation of corporate income tax payments that might represent an additional cost.
AFACs are similar to shareholder loans, but the principal differences are that they are not normally subject to interest and can be treated as debt or equity for accounting purposes, depending on the terms established.
Shareholder loan structures were commonly implemented based on the financial and tax advantages over equity financing, rather than on an analysis of the alternatives considering the business reasons. However, due to the evolution of Mexican and international tax laws in recent years, it is important that investors evaluate if shareholder loan structures are viable and assess the potential tax risks attached.
One of the first steps of this evaluation should be to analyse if shareholder loan structures would be viable considering the general anti-avoidance rule provided in Article 5-A of the Federal Fiscal Code. This legislation specifies that Mexican tax authorities can disregard transactions for tax purposes if they do not have a valid business reason behind them. This could be a complex analysis considering that as of today, no public legal precedents exist in Mexico to understand the tax authorities’ position.
The Mexican Income Tax Law also dictates that if loan transactions do not have a valid business reason, tax authorities can treat them as ‘back-to-back’, meaning that interest should be considered as deemed dividends.
As outlined in the OECD Transfer Pricing (TP) Guidelines, the business reason in loan transactions should be analysed from the lender’s and borrower's perspective. From the borrower's perspective, some of the business reasons that should be analysed are:
Availability of funds;
Cost of debt financing; and
From the lender’s perspective, some of the business reasons that should be analysed are:
Terms of payment obligations with other parties; and
Investment options realistically available.
Particular attention should be paid when only one investor (or a majority investor) makes an investment and wants to implement shareholder loans. From a lender's perspective, it would be difficult to argue that the use of shareholder loans derived from a valid business reason rather than from the tax consequences of the structure. In other words, the investor would be bearing the same business risk investing through equity or debt.
Other relevant tax considerations on shareholder loan structures are those in line with Action 4 of the BEPS project by the OECD. Mexican tax authorities incorporated diverse tax provisions many years ago to prevent tax base erosion through excessive interest deductibility and the avoidance of dividend taxation.
Some of these provisions are:
An interest deductibility limitation of 30% on the borrower’s tax EBITDA;
The non-deductibility of payments to foreign resident parties that are subject to a preferential tax regime; and
The recent limitations on tax benefits granted to Sociedades Financieras de Objeto Múltiple (SOFOMs), when they mainly carry out transactions with related parties.
Therefore, a detailed review of the outlined provisions should be conducted whenever a shareholder loan is to be implemented in Mexico. Calculating the correct debt or equity measures for a company is not a one-size-fits-all procedure and it depends on the specific circumstances of each company.