Some years ago, it was very common to use foreign vehicles to promote and channel private equity investments in Mexico, such as Canadian limited partnerships, which were, and still are, widely used in Mexico considering their legal and tax transparency.
However, Mexico has undergone significant regulatory changes, including modifications that expanded the scope of allowed investments for investment companies specialized in retirement funds (SIEFORES).
Such modifications, together with other changes made to tax regulations in recent years, have broadened the type of vehicles (local and foreign) that are nowadays used in Mexico for this purpose, which include Canadian limited partnerships, US limited partnerships, US limited liability companies, several types of Mexican fideicomisos, such as regular non-business fideicomisos, real estate investment fideicomisos (FIBRAs), and private equity investment fideicomisos (FICAPs), among others.
In general terms, these investment vehicles could be classified as follows:
1) Transparent figures (local and foreign)
The principal tax advantage of using a transparent figure is that it is completely disregarded for tax purposes, as if the corresponding income had been directly obtained by its investors.
For Mexican tax purposes, corporations and others that have legal capacity of their own are considered to be ‘entities’, whilst a ‘figure’ is something that has no legal capacity of its own. An entity or figure is deemed as ‘transparent’ when it is not considered as a taxpayer in its country of incorporation, and therefore the corresponding income is attributed to its members or beneficiaries.
Therefore, investors are allowed to apply benefits contained in the treaty entered into by Mexico with their country of residence, if any, regardless of the jurisdiction in which the figure was incorporated, to the extent applicable requirements are met.
These vehicles, since they are completely disregarded for tax purposes, do not represent a risk of treaty abuse; on the contrary, they are used with the intention that investors are taxed under their applicable tax regime, which may include the application of benefits under their respective treaties. Treaty abuse may exist depending on the way in which each investor structures its own investment.
2) Foreign regular entities
These are normally treated as tax ‘blockers’ in Mexico, even if they are deemed as fiscally transparent in their country of incorporation. Accordingly, in order to determine the possibility of applying treaty benefits in these cases, the relevant tax residence would be, in principle, that of the blocker (not of the investors).
The application of such treaty benefits may still be subject to the compliance of certain ‘substance’ requirements (ie. limitation-on-benefits rule or ‘LOB rule’), in which case the tax residence of the investors, among other factors, may become relevant.
However, in some treaties, requirements of this kind are not even included and, in others that do include them, such requirements may be insufficient to prevent treaty abuse. This issue is addressed in more detail below.
3) Foreign transparent entities
An exception to the tax treatment generally applicable to foreign entities in Mexico is entities that opt to be treated as fiscally transparent in their country of residence and whose investors are totally or partially US tax residents.
This special treatment is based on a mutual agreement between Mexico and the US according to which a fiscally transparent entity may be treated as a US resident and entitled to claim benefits of the Mexico-US tax treaty, to the extent that the income it derives is subject to US taxation in the hands of its members or beneficiaries.
In this case, since treaty benefits only apply as long as there are US investors in the vehicle (in the proportion in which they participate in it), the use of this type of vehicles does not represent a risk of treaty abuse.
4) Foreign regular entities with a special tax regime
Under Mexican tax law, there are cases in which the income obtained by the foreign vehicle may be granted a special tax regime, depending on who its owners are.
This is the case for qualifying income (rental income and capital gains) obtained by foreign entities through which foreign pension funds invest in Mexico, which is considered as exempt for Mexican tax purposes provided that certain requirements are met.
Global concerns and implications of Action 6
Governments around the world are worried about treaty shopping practices engaged in by investors mostly for tax-driven reasons when deciding the investment vehicle and jurisdiction to be used, with the intention of claiming treaty benefits in situations where such benefits would not have applied had the investment been made directly.
In order to address this issue, among others, in September 2013 the OECD and G20 countries adopted a 15-point action plan in order to ensure that profits are taxed where the economic activities take place and the value is created; this plan is known as the Base Erosion and Profit Shifting (BEPS) project.
As part of the BEPS project, Action 6 “Preventing the granting of treaty benefits in inappropriate circumstances”, which addresses treaty abuse (particularly treaty shopping practices), recommends dealing with such abuse through the following rules:
a) LOB rules allowing the entitlement of treaty benefits if certain conditions are met; and
b) A principal-purpose-test rule (PPT rule) which would address abuse not covered by LOB rules and would deny benefits if it is concluded that one of the principal purposes of a transaction or arrangement was to obtain such benefits.
In order to define adequate policies, the OECD distinguishes between two types of investment funds – collective and non-collective investment funds – which may take several forms (ie. companies, trusts, partnerships, contractual arrangements, among others).
Collective investment funds (CIVs) are defined as those that are widely-held, hold a diversified portfolio of securities and are subject to investor-protection regulation in the country in which they are established. There is no specific definition for non-collective investment funds (non-CIVs), but by simple elimination it is inferred that they correspond to funds that do not fit into the definition of CIVs. However, this classification must be done carefully, since non-CIVs share many of the characteristics of CIVs. For example, private equity funds may have a broad investor base and may also invest in a broad range of jurisdictions and assets. Private equity funds, among others, are generally identified as non-CIVs.
Important issues discussed in Action 6 are:
i. Whether such vehicles shall be allowed to claim benefits on their own behalf, which would depend of their legal nature and tax residence status (ie. if they are persons liable to tax in their respective country).
ii. If these vehicles can be considered as beneficial owners of the income they receive, which would depend on who exercises the powers to manage the assets (ie. the investors or a manager).
iii. CIVs that are not subject to any taxation in their country may present more danger of treaty shopping.
iv. A general anti-treaty shopping provision could be adopted, which would determine whether owners of the CIV (or a specific proportion of them) are residents of the fund’s country, or whether such owners would have been entitled to equivalent benefits had they invested directly; application of treaty benefits would be allowed in the proportion in which owners meet any of these conditions.
v. A different approach could be granting the CIV full benefits on all the income it receives, if such vehicle passes a threshold of ‘good’ ownership.
vi. Another possibility could be giving the CIV a look-through status; this could be the case where pension funds are substantial investors, in which case the source country could grant a treaty exemption on qualifying income.
vii. The CIV would need to make a determination as to who are its investors (and, more importantly, its beneficial owners). This task becomes more complicated as each investor adds several layers of intermediate vehicles, but could become easier in the years to come, since as of today many countries have in place anti-money laundering laws (which include ‘know your client’ procedures)and automatic exchange of information agreements (FATCA and CRS).
The main issues that are discussed are:
i. The OECD recognises the economic importance of non-CIVs and the need to ensure that treaty benefits are granted where appropriate.
ii. There are still two major concerns regarding the use of non-CIVs: (1) providing treaty benefits to investors that are not directly entitled to such benefits; and (2) deferring recognition of income by investors on which treaty benefits have been granted.
iii. In order to address these concerns, in March 2016 the OECD published a document regarding the entitlement of non-CIVs to treaty benefits, which includes comments that have been made by organisations of different countries and also provides additional questions. Follow-up comments have been issued regarding these additional queries.
iv. A common suggestion is that an exception to LOB rules shall be given to non-CIVs that are ‘widely held’ or ‘regulated’ (ie. a non-CIV would not qualify as ‘widely held’ if a certain percentage of the fund is owned by a single or related persons).
v. Whether it would be relatively easy for a non-CIV to be used primarily to invest on behalf of a large number of investors who would not otherwise be entitled to treaty benefits, fund managers seek a large investor base to create a long term relationship, which means that creating a fund for a group of non-treaty investors would reduce drastically such base, as it would exclude institutional investors who are in fact allowed to apply treaty benefits.
vi. In the case of transparent entities, it is mentioned that treaty benefits shall be available to an investor in a non-CIV as long as the latter is treated as transparent by the country of residence of that investor, so that the investor is taxed directly on its share of the corresponding income.
vii. Another suggestion is that the LOB clause could include a derivative benefits rule, according to which the non-CIV would be entitled to treaty benefits if it meets certain conditions and has a sufficiently high level of investors (ie. 80%) who would be entitled to the same or better benefits (such as pension funds).
viii. A different approach could be granting benefits to a non-CIV that has a “sufficiently substantial connection’ with its country of residence, based on criteria such as the residence of board members or managers, their expertise, the jurisdiction in which board decisions are made, etc. Additional requirements could be established (ie. that funds are more than 50% owned by institutional investors).
ix. Another solution would be to apply a global streamed fund (GSF) system, according to which an exemption would apply to qualifying funds, which would have the obligation to distribute their income on a regular basis. The tax (determined by the treaty entitlement of the ultimate investor under the treaty between its country of residence and the country of source) would be collected upon distributions by the country of residence of the fund and would be remitted to the country of source of the income.
x. Concerns were expressed regarding the scope of the PPT rule, since having a subjective test creates potential for uncertainty, as there may be a lot of facts to be taken into consideration. Therefore, objective tests in principle would be preferable.
xi. As in the case of CIVs, another issue that is addressed is if it would be possible for non-CIVs to identify their ultimate beneficial owners.
Effects of Action 6 for private equity funds in Mexico
In the specific case of Mexico, the proposed anti-abuse rules (LOB rules and/or the PPT rule), if incorporated into its tax treaty network, may affect the entitlement of treaty benefits when the investment vehicle is a foreign regular entity, or a foreign transparent entity (assuming Mexico decides to recognize such transparency in cases different from that in which investors are US residents). However, the implementation of these measures shall not affect those cases in which the investment vehicle is a transparent figure.
The challenge for governments, including Mexico’s, will be to introduce measures that make sense in each specific case, taking into account the particular situation of each country and its relationship with other countries; in some cases it may be advisable to include them as currently proposed by the OECD, but in others it may be necessary to modify them.
Governments shall be aware that in many cases obtaining treaty benefits is far from being the principal reason to choose a given type of vehicle and jurisdiction; rather, investors take into account factors such as diversification of risk, access to international markets, reduced costs, sophisticated management teams and higher returns, among other business, regulatory, financial, administrative and investor-protection reasons.
Therefore, Mexico should pay special attention when trying to incorporate these rules into its treaties; otherwise, investors may look for other countries in which they are given legal certainty that the vehicle would be allowed to apply treaty benefits.
Authored by Alfredo Sánchez Torrado and Eduardo García Ruiz at Chevez Ruiz Zamarripa in Mexico.
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