Tax transparent vehicles’ entitlement to benefits under the Mexico–US tax treaty
Sebastián Ayza and Federico Scheffler of Galicia Abogados explain the conditions under which a US fiscally transparent vehicle with Mexican-sourced income is entitled to Mexican tax relief.
Tax residency of fiscally transparent vehicles
The tax transparency of foreign legal entities or legal arrangements (foreign vehicles) deriving Mexican-sourced income is generally not recognised for Mexican tax purposes. This is consistent with Mexico’s international position on the tax transparency of foreign vehicles under Article 4-A of the Mexican Income Tax Law (ITL).
Accordingly, foreign vehicles are treated as tax opaque in respect of Mexican-sourced items of income irrespective of the fact that, under their governing tax law, income is attributed to their partners or beneficiaries.
As an exception to the above, Article 4-A of the ITL provides that this domestic provision cannot override a provision contained in a tax treaty entered into by Mexico that recognises the tax transparency of a given foreign vehicle. That is, Mexican tax authorities cannot apply Article 4-A in respect of Mexican-sourced income derived by foreign vehicles whose tax transparency is recognised under a tax treaty in effect.
That is the case with the Mexico–United States tax treaty (the Double Taxation Agreement, or DTA). Pursuant to articles 4(1) of the DTA and 2(b) of the Protocol thereto, a partnership, estate or trust may qualify as a resident of a contracting state only to the extent that the income it derives is subject to tax in that state as the income of a resident, either in the hands of the partnership, estate or trust, or in the hands of its partners or beneficiaries.
Furthermore, the 2005 Competent Authority Mutual Agreement establishes that “it is understood that income from sources within one of the Contracting States [for example, Mexico] received by an entity that is organized in either of the Contracting States [for example, Mexico or the US], or a third party state with which Mexico has in force a comprehensive exchange of information agreement, and that is treated as fiscally transparent under the laws of either Contracting State will be treated as income derived by a resident of the other Contracting State to the extent that such income is subject to tax as the income of a resident of the other Contracting State.
“For Mexican tax purposes, a fiscally transparent entity organized in the United States, such as a US limited liability company (LLC) that has elected to be treated as a partnership for federal tax purposes, will be treated as a US resident […] and entitled to claim treaty benefits, to the extent that the income it derives is subject to tax as the income of a US resident in the hands of its members, owners, partners, or beneficiaries. Similar rules will apply to a US subchapter S Corporation, an LLC that is disregarded as an entity separate from its owner, or a US grantor trust.”
Therefore, in so far as Mexican-sourced items of income derived by a US fiscally transparent vehicle are subject to taxation in the US, either at the level of the fiscally transparent vehicle or that of its partners or beneficiaries, that vehicle would qualify as a US resident for DTA purposes with regard to the portion of Mexican-sourced income on which US taxes are levied.
Nevertheless, the fact that a US fiscally transparent vehicle qualifies as a resident for DTA purposes is not sufficient for it to be entitled to relief thereunder, as described below.
Limitation on benefits clause
To prevent treaty-abusive practices, specific safe harbour provisions relating to the applicability of DTA benefits were included in Article 17.1 of the DTA (the LOB Clause).
The LOB Clause sets forth a series of objective criteria that must be satisfied for a resident to be entitled to claim DTA benefits.
The safe harbour provisions under the LOB Clause are meant to be self-executing. That is, taxpayers are required to assess whether they meet any of the safe harbour provisions set forth under the LOB Clause, as opposed to taxpayers requiring approval or a ruling from the appropiate taxing authority to be entitled to claim DTA benefits. The foregoing is irrespective of the fact that under Article 17.2 of the DTA, if a resident does not satisfy any of the self-executing safe harbour provisions set forth in the LOB Clause, a ruling or approval could be requested from the taxing authorities to apply DTA benefits.
As a result, the following conditions must be satisfied for a vehicle that is regarded as fiscally transparent for US tax purposes to be entitled to claim DTA benefits in respect of Mexican-sourced items of income:
Income derived by it must be subject to tax in the US at the hand of the relevant vehicle or that of its partners or members to qualify as a US resident for DTA purposes;
At least one of the self-executing safe harbour provisions under the LOB Clause must be satisfied; or
If none of the safe harbour provisions is satisfied, an approval or ruling must be obtained in terms of Article 17.2 of the DTA to claim benefits thereunder.
In general terms, the safe harbour provisions under the LOB Clause can be classified as follows:
Individuals who qualify as US residents for DTA purposes are entitled to claim DTA benefits;
A contracting state, a political subdivision or local authority thereof is entitled to claim DTA benefits;
Subject to the conditions described in the DTA, tax-exempt organisations (such as pension funds) are generally entitled to claim DTA benefits;
Public companies whose shares are regularly traded in substantial volume on an officially recognised securities exchange are entitled to claim DTA benefits;
Private corporations that are wholly owned subsidiaries of a publicly traded company and private corporations in which at least 50% of their capital stock is owned, directly or indirectly, by one or more companies that are residents of the US and/or Mexico, and the remaining interest in such entities is owned by publicly traded companies that are residents of any country that is a party to the North American Free Trade Agreement (now replaced by the United States–Mexico–Canada Agreement, or USMCA), would qualify for DTA benefits;
Businesses engaged in the active conduct of a trade or business in their state of residence (for example, the US) that derive income from the other contracting state (for example, Mexico) in connection with, or incidental to, such trade or business are entitled to claim DTA benefits (for these purposes, the business of making or managing investments, unless carried out by banking or insurance companies, does not satisfy the ‘such trade or business test’); and
Based on an ownership and base erosion test, DTA benefits could be granted:
If more than 50% of the beneficial interest of a company is owned, directly or indirectly, by persons entitled to claim DTA benefits under the preceding safe harbour provisions, excluding the active trade or business test, and less than 50% of the company’s income is used, directly or indirectly, to make deductible payments (for example, interests and royalties) to persons not eligible for DTA benefits; or
If more than 30% of the beneficial interest of a company is owned by Mexican or US residents entitled to DTA benefits (except under the active trade or business test), and more than 60% is beneficially owned by residents of USMCA member states, provided that less than 70% of the gross income of the company is used to meet liabilities to persons other than Mexican or US residents entitled to DTA benefits, and less than 40% of its gross income is used to meet liabilities to persons other than Mexican, US or Canadian persons.
Of the above-mentioned safe harbour provisions, the active trade or business test is of particular interest in light of the nature of fiscally transparent entities and the concept of beneficial ownership for DTA purposes.
The importance of construction
Under a narrow construction of the active trade or business test, the analysis should be conducted on a standalone basis at the level of the vehicle deriving the Mexican-sourced income. That is, if a fiscally transparent entity that qualifies as a US resident were to claim DTA benefits, a narrow construction would require that the active trade or business test be conducted at the level of that tax-transparent vehicle and not at the level of its partners or beneficiaries.
However, taking into account that the US fiscally transparent entity would only qualify as a US resident as a result of its income being taxed at the level of its partners or beneficiaries and that such income effectively flows through to the latter for US federal income tax purposes, it could be argued that the active trade or business test should be conducted at the level of the partners or members who would (in this example) beneficially own the Mexican-sourced income. This construction could be strengthened by the following arguments:
The tax-transparent US vehicle only qualifies as a US resident for DTA purposes to the extent that income derived by it is taxed at the level of that vehicle or that of its partners or beneficiaries.
In terms of Section 2 of the 2005 Competent Authority Mutual Agreement, a US partnership is entitled to credit its tax residence for DTA purposes in terms of Form 6166, which “will inform the withholding agent to contact the LLC directly to provide information regarding the allocation of a particular payment to a specific member”.
DTA benefits relating to dividend and interest income are conditioned by articles 10.2 and 11.2, respectively, to them being obtained by the beneficial owner.
As detailed in the 2003 US Treasury Department Technical Explanations to the DTA’s Second Protocol, “Companies holding shares through fiscally transparent entities such as partnerships are considered for purposes of this paragraph [in respect of the beneficial owner] to hold their proportionate interest in the shares held by the intermediate entity. As a result, companies holding shares through such entities may be able to claim the benefits of subparagraph (a) under certain circumstances. The lower rate applies when the company’s proportionate share of the shares held by the intermediate entity meets the 10 percent threshold”.
Likewise, articles 11.2, 11.3 and 11.4 limit the right of the source state (for example, Mexico) to tax interest beneficially owned by a resident of the other contracting state (for example, the US). That is, the analysis on the applicability of DTA benefits is conditioned to the interests being beneficially owned by a person that qualifies as a US resident and that satisfies the LOB Clause.
Accordingly, with respect to dividend and interest income derived by fiscally transparent vehicles that qualify as US resident for DTA purposes, the LOB Clause analysis should be conducted at the level of the beneficial owner; that is, the taxpayer that owns such income and will be liable to tax in the US in connection with such items of income, thus enabling the fiscally transparent vehicle to qualify as a US resident for DTA purposes in the corresponding proportion.
Therefore, if a US taxpayer (such as a US resident corporation) holding an interest in a fiscally transparent vehicle (for example, a US partnership) is engaged in the active conduct of a trade or business in the US (other than making and managing investments), and the Mexican-sourced income derived by the fiscally transparent vehicle is connected thereto (or is incidental thereto), DTA benefits should be applicable in proportion to the portion of the income attributed to the US taxpayer that is subject to tax in the US.
However, under the same scenario, if the US taxpayer does not satisfy the active trade or business test, DTA benefits should not be applicable with respect to the items of income derived by the fiscally transparent vehicle, unless it were to obtain an approval or favourable ruling from the taxing authority in terms of Article 17.2 of the DTA.