Tax residency issues on structuring Mexican venture capital investments
Venture capital funds and investors often fail to give due consideration to the Mexican tax residence rules, say Oscar A. López Velarde and Gabriel Márquez García of Ritch Mueller.
It has become a trend to invest in Mexican start-ups using Cayman entities or US limited liability companies (LLCs) that are not subject to US taxes, but it seems that the majority of venture capital funds and investors are not taking into consideration the Mexican tax residence rules.
A zero-tax holding structure looks, in principle, inefficient for an investment in Mexico, which has very high withholding taxes on capital gains (25% on gross value without any deductions) and dividends (10%). Neither Cayman entities nor US LLCs are eligible to claim treaty benefits. However, using a ‘carrier pigeon’ company still provides flexibility to define the final holding structure at a later stage when there is more visibility of the potential exit strategy or the markets in which the start-up’s business will become commercially successful.
While these structures were initially intended as a bridge or transition to the final structure of a business still under construction, the majority of investors and fund managers are now planning to take advantage of the fact that an indirect transfer of Mexican shares, if not rich in land, is not subject to tax in Mexico and are starting to underwrite investments in Mexico assuming that there will be no capital gains taxes if they sell the Cayman entity or the US LLC.
For such planning to work, the offshore holding company should not be treated as a Mexican tax resident.
However, it seems that everybody is losing sight of the fact that tax residence is not determined in Mexico based on the place of incorporation of an entity or a vehicle but rather by other factors, which generally lead to an evaluation that such holding companies are Mexican tax resident companies, regardless of whether they were incorporated in the Cayman Islands or the US.
The Federal Fiscal Code criteria
In terms of Article 9 of the Federal Fiscal Code (FFC), a legal entity should be treated as a resident in Mexico for tax purposes if it has established therein:
The main place for the administration of the business; or
The place of effective management of the business.
Article 6 of the regulations of the FFC further provides that a legal entity will be considered to have established the main place for the administration of the business or place of effective management in Mexico when the place in which the person or persons that take or execute the (i) control, (ii) direction, (iii) operation or (iv) management decisions of the entity in question and the activities it engages in are located in Mexico.
Although the Mexican tax residence definition differs to a certain extent from the OECD definition, paragraph 24.1 of the OECD commentary on Article 4.3 of the Model Tax Convention, which Mexican courts commonly use for the interpretation of international tax terms, provides various questions that should be taken into account to determine where the tax residence of a company is located:
Where are the meetings of the person’s board of directors or equivalent body usually held?
Where do the CEO and other senior executives usually conduct their activities?
Where are the senior day-to-day management activities of the person carried out?
Where is the person’s headquarters located?
What are the country’s laws that govern the person's legal status?
Where are the accounting records of the person kept?
At present, the majority of the holding structures of Mexican start-ups remain managed by their founders in Mexico and the majority of their operations remain in Mexico, and only certain board members or directors who are regularly employees of a trust management company and do not have real power of any kind are appointed outside Mexico.
This fact pattern leads to the conclusion that the majority of such holding companies are Mexican tax residents and that the sale of their shares remains subject to Mexican income tax.