Over the past several months, oil prices have dropped substantially, leading to material revenue shortfalls in oil exporting countries. This effect has impacted the Mexican economy, since exports of crude oil represent fiscal revenue in the hands of Petroleos Mexicanos, which is owned by the Mexican state.
Income from oil exports represents nearly one-fifth (19.7%) of Mexican GDP, according to OECD figures from 2014. Historically, the price of crude is used as an economic indicator and a public policy planning tool. Throughout 2015 the Mexican blend of crude oil has been traded at an average price of less than US $50 per barrel, which compares with the maximum value of more than US $102 per barrel that was reached in the first quarter of 2012.
In late 2013, after the Congress approved the tax reform for 2014, President Enrique Peña Nieto publicly committed not to propose new taxes or tax increases in the remainder of his administration, unless macroeconomic conditions underwent a significant change. Despite the sustained drop in oil revenues, on September 2 2015 Peña Nieto reaffirmed this commitment not to pursue tax increases.
The decrease in revenues and the inability to counteract this with new taxes or through tax rate increases has led the Mexican tax authorities to take base-broadening measures that may allow them to increase tax revenue by utilising the already-existing taxes and collecting larger amounts of taxes from those who have usually been regular taxpayers.
This approach explains why, in the last two years, Mexican taxpayers have seen a significant increase in the number of tax audit processes, and why the procedures and measures used by the tax authorities to assess taxes in such audits have been tightened.
Tax audit trends
Tax audits conducted by the tax authorities in recent years have focused strongly on verifying the materiality of transactions reported by taxpayers. To do so, the authorities adopt a substance-over-form approach that in some cases goes beyond the powers granted to them in the relevant provisions.
The authorities collect information from the taxpayers' annual tax reports, from their file of annual tax returns and from general data publicly available at the Mexican Stock Exchange (Bolsa Mexicana de Valores). The authorities have publicly stated that, by processing data obtained from these sources, they have been able to identify common patterns allowing them to set well-identified criteria to determine when audit processes should be initiated for a specific taxpayer or for a collection of taxpayers belonging to a common group (grouped, for example, by type of industry or by level of revenue).
According to information provided by the tax authorities in public fora, such criteria may be classified as shown in Table 1.
|1. Tax and financial results||1. Track record of previous tax audit processes|
|2. Debt-equity structure||2. Participation in ‘aggressive tax planning’|
|3. Transactions with related parties||3. Openness and transparency|
|4. Acquisitions, sales and restructures||4. Lack of corporate governance|
|5. Unusual and complex transactions|
|6. Cross-border transactions|
|7. Growth of assets vs. revenue ratio|
|8. Growth of liabilities vs. revenue ratio|
|9. Analysis of expenses incurred|
Tax and financial indicators to which the authorities pay particular interest include whether a taxpayer reported having incurred in tax losses in the preceding years, a decrease in taxable revenue with respect to the preceding tax year, a decrease in the annual tax profit, and the amount paid to non-resident related parties.
In line with this, the authorities have recently been performing tax audits on groups of taxpayers by focusing on transactions they have identified a as 'aggressive', according to their criteria. The authorities have continued to keep special interest not only in these identified transactions but more recently also on deductions claimed by taxpayers derived from intragroup services.
Relevant issues identified in recent tax audits include the following:
- Leasing of commercial equipment. The issue has been raised as to whether rental payments made by taxpayers should be treated as royalty payments, and whether any tax should be withheld on such amounts when dealing with payments made abroad. Mexico does not follow the position of the OECD Model Convention, and therefore payments for the lease of industrial, commercial and scientific equipment are treated as payments of taxable royalties.
- Supply chain restructures. Focus continues to be centred on determining whether the decision to reallocate assets out of Mexico is primarily tax driven. In recent years, the authorities have made significant assessments of multinational groups which, in their view, failed to demonstrate the substance of the restructures. Such decisions have ultimately been upheld by the relevant courts.
- Pro-rata expenses. In 2014, the courts established that a comprehensive and well-defined set of requirements must be met in order for taxpayers to be allowed to deduct expenses allocated on a pro-rata basis. To the extent that taxpayers are able to demonstrate – through the relevant documentations – that such requirements are met, deductibility should be allowed. Thus, when dealing with this issue, taxpayers are forced to provide substantial arguments as well as thorough supporting documentation to demonstrate full compliance.
- Cash pooling. Business reasons for the setting up an intragroup financing entity are challenged. If authorities deem that the transaction lacks substance, deductibility of interest payments arising thereof may be disallowed.
- Country risk adjustments. In one of the most recent trends shown by the authorities, they have tried to argue that arrangements between related parties do not properly consider Mexico's country risk exposure. Accordingly, they have sought to adjust upwards payments on which additional tax can be assessed.
- Royalties should include advertisement expenses. When payments are made to a non-resident who owns the legal property of an intangible asset (for example, trademarks and patents), the authorities have sustained that only such owner of the intangible is allowed to deduct advertisement expenses that may increase the value of the intangible asset in Mexico. The authorities have thus sought to disallow the deduction made by the Mexican subsidiary who ultimately made use of the intangible asset in the country.
- Dividends. The authorities have intended to re-characterise dividends paid to non-resident shareholders as a different kind of income on which Mexican income tax could be assessed (for example, interest payments). Additionally, they try to verify that dividend withholding tax (in force since 2014) is properly withheld by Mexican dividend paying entities.
Focus on formal requirements
Following its civil law tradition, Mexico continues to be a very formalistic country for tax purposes and prioritises documentary evidence to support a transaction. For instance, the lack of documentation may cause the Mexican tax authorities to disallow a deduction that does not meet certain minimum evidence requirements. In other cases, failure to provide the information requested in an audit process has resulted in the re-characterisation of specific transactions or the denial of valid deductions.
Therefore, while focusing on proving the materiality of transactions, the authorities have not lost sight of the formal requirements that are to be met in order for taxpayers to properly support transactions.
One example is the refund requests for VAT. Taxpayers must face complex and thorough verification processes to demonstrate that the transactions from which favourable VAT balances derive were actually carried out and at the same time aim to verify that all formal requirements provided in the relevant provisions were met while carrying out such transactions and while requesting the refund of the amounts. The business rationale provided for amounts paid by taxpayers is also questioned during this process.
The interest of the authorities on (related or unrelated) parties with which the taxpayer carried out transactions and on whether such parties properly meet their tax payment obligations has also increased. Consequently, it has became a common practice for the authorities to request information from such third parties. The scope of the reviews has even sought to verify whether these third parties have ultimately remitted the VAT collected by them from the taxpayer who requests the refund.
These processes mean it can take the authorities more than one year to review and ultimately authorise the refunds. In this way, the tax authorities have been able to retain, for longer periods, indirect taxes collected from taxpayers, which has certainly represented for them additional short-term financing shortfalls.
Taxpayers may sue the tax administration for this practice, but litigation is costly and time consuming, and therefore more commonly mediation by the tax ombudsman or PRODECON is sought.
Possible arbitration through conclusive agreements
In 2014, an alternative dispute settlement method for fiscal matters known as 'conclusive agreement' was included in the Federal Fiscal Code. This method intends to allow settlements between the authorities and taxpayers related to tax audit processes to be reached with the participation of the PRODECON as an unbiased mediator between the parties.
The procedure to request the adoption of a conclusive agreement can be initiated at any moment once the powers of verification of the tax authorities have been exerted, as long as acts and omissions related to the taxpayer's tax situation have been detected by the authorities. This occurs in the last interim report that in its case is issued and before the provision of a document notifying the taxpayer of pending assessment.
It is important to notice that the adoption of a conclusive agreement by the taxpayer suspends the terms provided in the law for the termination of the respective audit process from the moment in which adoption is requested and until it is settled.
When an agreement between the parties is reached, the conclusive agreement is signed and the dispute is deemed concluded under the terms agreed. The fact that the parties reach an agreement does not imply that the taxpayer consents to the observations made by the authority during the audit process.
When an agreement is reached, 100% of the penalties that would otherwise be applicable are waived. This is applicable only in the first conclusive agreement entered into by the taxpayer.
Furthermore, if the parties do not reach an agreement, the audit process resumes from the time of its suspension. When an assessment is made, the taxpayer's right to challenge such assessment through the applicable legal remedies would be preserved.
Based on information provided by the PRODECON for 2014, 873 conclusive agreement adoption requests were filed from the period of January 1 2014 to November 30 2014.
Influence of BEPS Action Plan in Mexico
In 2013, before the first draft of the tax reform for 2014 was submitted to the Congress for discussion, the Mexican tax authorities anticipated their intention to include BEPS-based rules within the Mexican tax legislation. Accordingly, in 2014 Mexico became the first OECD member country to incorporate into its tax legislation rules considering the BEPS Action Plan published by the OECD.
Indeed, in the comprehensive tax reform, approved by Congress in late 2013 and entering into force on January 1 2014, different BEPS-based rules, primarily intended to curtail deductions, were incorporated into the Mexican Income Tax Law, namely:
- Limitations of deductibility of payments made to entities on which the corresponding income is subject to preferential tax regimes (anti-tax haven legislation);
- Limitation to deduct payments made that are also deductible for a related party resident in Mexico or abroad; and
- Limitations of interest, royalty and technical assistance payments made to non-resident related parties when the recipient of the payments is disregarded or tax transparent in its country of residence, or where the income is disregarded.
Additionally, as of 2014 the application of benefits derived from tax treaties Mexico has entered into is subordinated by the ability of non-resident taxpayers to demonstrate that they are actually subject to juridical double taxation with respect to the transaction in which they wish to claim treaty benefits.
It is notable that despite the recent visible focus of the Mexican tax authorities on transfer pricing issues related to cross-border transactions, as of today no specific measures have been incorporated into Mexican legislation in line with what is set out in BEPS Action 13: Guidance on the implementation of transfer pricing documentation and country-by-country reporting.
However, the tax Bill that was recently filled by the executive branch to the Congress included an obligation for Mexican-resident taxpayers to file new informative tax returns of related parties:
- master file of the business multinational group;
- local informative file of related parties; and
- country-by-country informative return of the business multinational group.
2016 tax reform
On September 8 2015, the executive branch submitted a tax Bill to the Mexican Congress, which contains several amendments to the federal tax laws already in force. If approved, the proposed amendments would apply in 2016. The proposed Bill for tax year 2016 will be subject to discussion and approval by the Mexican Congress.
Some of the most important modifications that are being proposed in connection with income tax are the following:
- To eliminate the generality principle applicable to fringe benefits granted to non-union workers, as well as the limit to deduct such benefits;
- To exclude from thin capitalisation computation the debts incurred in connection with the investment in infrastructure related to electric power generation;
- To include the obligation of filing the aforementioned transfer pricing informative returns of related parties;
- To entitle taxpayers engaged exclusively in the generation of energy from renewable sources or cogeneration system of efficient electricity to maintain a profit account for investment on energy sources, instead of the CUFIN [net after-tax profit account]. Additional tax on dividends would not apply for dividends distributed from such account;
- To allow to small taxpayers, for tax years 2016 and 2017, the net present value deduction of assets;
- To eliminate the requirements applicable to trusts for investment in venture capital (FICAPs) that implies that their maximum duration must be of 10 years;
- To establish a temporary procedure for legal entities and individuals to repatriate offshore investments held until December 31 2014 for which income was generated, including that from tax havens. Interest and penalties are waived if the taxpayer chooses to repatriate the funds and invest them in Mexico; and
- To incorporate several rules with the purpose of accelerating and simplifying the exit process from the tax consolidation regime.
It is necessary to stress that, after discussion by the Mexican Congress, these modification proposals may be subject to change.
José Carlos Silva
Chevez, Ruiz, Zamarripa y Cía
José Carlos Silva is a partner at Chevez, Ruiz, Zamarripa y Cía in Mexico City. His main areas of specialisation are international taxation matters and tax treaty practices.
He is member of the faculty of the Accounting Department of the Instituto Tecnologico Autonomo de México (ITAM). Jose Carlos is an active member of the International Fiscal Association (IFA) and is a member of the association's Permanent Scientific Committee.
Chevez, Ruiz, Zamarripa y Cía
Bernardo is an associate at Chevez, Ruiz, Zamarripa y Cía in Mexico City. He is specialised in federal taxation matters in Mexico, with emphasis in cross-border transactions and investment structures. Bernardo is a public accountant from Instituto Tecnológico Autónomo de Mexico (ITAM) in Mexico City, where he took a postgraduate course in corporate advisory. He holds a master's degree in international taxation from the University of Sydney in Sydney, New South Wales, Australia and took a postgraduate course in energy law at the Escuela Libre de Derecho in Mexico City.
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