Mexican tax considerations on cross-border loans
Oscar Lopez Velarde and Pablo Múgica Ortiz of Ritch Mueller analyse certain peculiarities in cross-border syndicated loans with Mexican-sourced interest.
The Loan Syndications and Trading Association’s (LSTA) model contract agreement provisions have become a standard in the American syndicated lending market that is active in Latin America, including Mexico. Despite the LSTA’s recent efforts to create a version for Latin American transactions, the LSTA model must be tailored for cross-border transactions, as it often does not capture the peculiarities of domestic tax regimes.
Cross-border loans granted to Mexico-based companies are usually governed by foreign law, typically New York’s. However, it is vital to remember that Mexican tax laws always regulate the fiscal implications of such loans in Mexico. Thus, even if credit agreement structures and legal consequences are subject to foreign jurisdictions, Mexican taxes would be determined under domestic law.
Mexican lenders, including permanent establishments of foreign residents, are subject to a 30% income tax rate and generally not subject to withholding; permanent establishments are subject to tax in the same terms as Mexican residents. Conversely, foreign tax residents without a permanent establishment in Mexico are subject to income tax on interest payments (and thus subject to withholding) when the capital that gives rise to the interest is placed or invested in Mexico. This also applies when it is paid by a Mexican tax resident or a non-Mexican resident with a permanent establishment in Mexico.
Mexican-sourced interest income may be subject to withholding rates ranging from an exemption to a 40% rate, with a default rate of 35%. The complexity of determining the applicable withholding rate in any cross-border operation is not particular to the Mexican market, but there are certain peculiarities that the parties should note in cross-border loans with Mexican-sourced interest.
Mexico has entered into double taxation treaties with more than 40 countries. Such treaties provide a default withholding tax rate of 10% or 15% on Mexican-sourced interest. However, such rates may be lower in the case of interest deriving from loans granted to or paid by banks (generally reduced to 4.9%) and in the case of loans granted by insurance companies from certain countries, such as the United Kingdom or the US. Additionally, the Mexican income tax law also provides a reduced 4.9% rate applicable to interest paid to foreign banks, non-bank financial institutions and investment banks that are residents of a treaty jurisdiction, despite the rate applicable under each treaty.
Regardless of whether withholding rates on Mexican-sourced interest may be reduced, lenders and borrowers will always want to take a close look at the “indemnified taxes” definition, which will cap the taxes that the parties will bear in connection with the contract.
Another complexity arises from the concept of beneficial ownership. The reduced 4.9% withholding tax rate on interest paid to foreign banks, non-bank financial institutions and investment banks, for example, is only applicable if they are the beneficial owners thereof. Moreover, Mexico includes a beneficial ownership clause in its tax treaties as an anti-avoidance measure to limit the application of the benefits provided on Mexican source interest.
As such, it is not advisable to allow participation in credits involving Mexican borrowers. Since interest payments are made to the lender, which in turn transfers them to the participant, the lender’s beneficial owner status could be challenged by the tax authorities, thus the default withholding rate of 35% provided in the Mexican income tax law would be applicable. As the concept is not clearly defined in Mexican tax legislation and has not been analysed in detail by Mexican courts yet, analysing any potential risks often implies resorting to international precedents.
Also, several matters should be considered when dealing with assignments involving Mexican lenders or assignees. By the very nature of assignments, interests are accrued by a person different from the original lender, so the applicable withholding rates may change. Thus, borrowers should seek to cap their gross-up in case the new lender faces higher withholding rates. Additionally, gains obtained by a non-resident:
From the assignment of a credit right payable by a Mexican resident; and
From the acquisition at a discount of a credit right from a Mexican resident
Are also deemed as interest for Mexican income tax law purposes and would therefore be subject to withholdings.
A market-standard agreement such as the LSTA model contract agreement provisions provides a good starting point for drafting a loan: it avoids unnecessarily burdening the parties with discussions about common practices. However, cross-border agreements will inevitably have to be adapted to account for the nuances of each specific case, especially when dealing with complex tax systems, such as the Mexican one.