A lot has been written about the programme recently launched and coordinated by the Organisation for Economic Cooperation and Development (OECD), designed to mitigate the impact of base erosion and profit shifting (BEPS) initiative. This article aims to highlight some of the transfer pricing implications of BEPS in Mexico, focusing on the effects and challenges of its implementation for both taxpayers and tax authorities. The first section of this article provides a brief description of BEPS. This section describes the action plan of the programme, detailing the 15 issues to be covered to avoid BEPS. The following section analyses the impact of BEPS in Mexico, including recent changes to the domestic tax legislation to incorporate key aspects of BEPS as well as a discussion on issues of economic substance in transfer pricing examinations. The last section presents final considerations. The major transfer pricing challenges that BEPS implies are also discussed in this part of the article.
Background to BEPS:
One of the main consequences of the 2008-2009 global financial crisis is the important fiscal deficits that governments from around the world are facing. As an example, the average government deficit in OECD countries is 4.07% of GDP for 2010-2012, while in some countries such as Ireland the deficit escalated to 17.27% of GDP. As one of the responses to that issue, the G20 has commissioned the OECD to develop a proper set of technical tools and policy guidelines to tackle the BEPS challenge.
The OECD's BEPS Action Plan provides for 15 actions scheduled to be finalised in three phases, the first one in September 2014, continuing to September 2015 and ending in December 2015.
A brief summary of the action plan is shown next:
- Action 1: Address the tax challenges of the digital economy: Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties;
- Action 2: Neutralise the effects of hybrid mismatch arrangements: Develop model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect (for example, double non-taxation, double deduction, long-term deferral) of hybrid instruments and entities;
- Action 3: Strengthen CFC rules: Develop recommendations regarding the design of controlled foreign company rules;
- Action 4: Limit base erosion via interest deductions and other financial payments: Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments;
- Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance: Revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime;
- Action 6: Prevent treaty abuse: Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances;
- Action 7: Prevent the artificial avoidance of PE status: Develop changes to the definition of permanent establishment (PE) to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions;
- Actions 8, 9 and 10: Assure that transfer pricing outcomes are in line with value creation:
- Action 8 – Intangibles: Develop rules to prevent BEPS by moving intangibles among group members. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements;
- Action 9 – Risks and capital: Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members. This will involve adopting transfer pricing rules or special measures to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. The rules to be developed will also require alignment of returns with value creation. This work will be coordinated with the work on interest expense deductions and other financial payments;
- Action 10 – Other high-risk transactions: Develop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties. This will involve adopting transfer pricing rules or special measures to: (i) clarify the circumstances in which transactions can be recharacterised; (ii) clarify the application of transfer pricing methods, in particular profit splits, in the context of global value chains; and (iii) provide protection against common types of base eroding payments, such as management fees and head office expenses;
- Action 11: Establish methodologies to collect and analyse data on BEPS and the actions to address it: Develop recommendations regarding indicators of the scale and economic impact of BEPS and ensure that tools are available to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS on an ongoing basis;
- Action 12: Require taxpayers to disclose their aggressive tax planning arrangements: Develop recommendations regarding the design of mandatory disclosure rules for aggressive or abusive transactions, arrangements, or structures, taking into consideration the administrative costs for tax administrations and businesses and drawing on experiences of the increasing number of countries that have such rules;
- Action 13: Re-examine transfer pricing documentation: Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNE's provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template;
- Action 14: Make dispute resolution mechanisms more effective: Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases;
- Action 15: Develop a multilateral instrument: Analyse the tax and public international law issues related to the development of a multilateral instrument to enable jurisdictions that wish to do so to implement measures developed in the course of the work on BEPS and amend bilateral tax treaties;
Although there are clear links between the different actions, this article is focused on Actions 4, 8, 9, 10 and 13, which are the ones that are undoubtedly related to transfer pricing. Also, it is worth mentioning that in a recent regional consultation on BEPS among the tax authorities from Latin American countries, the aforementioned actions are considered between the issues identified as important to the tax authorities of the region.
Transfer pricing aspects of BEPS in Mexico:
As the first discussions developed internationally on BEPS, there was a rapid response from various tax authorities. These actions were focused on enacting unilateral measures to mitigate the effects of BEPS in their respective countries. Ironically, this type of reaction is precisely one of the main concerns of the OECD:
"…BEPS is a global issue that requires global solutions. The international nature of tax planning means that unilateral and uncoordinated actions by countries will not suffice and may make things worse…"
"…Because many BEPS strategies take advantage of the interface between the tax rules of different countries, it may be difficult for any single country, acting alone, to fully address the issue. Furthermore unilateral and uncoordinated actions by governments responding in isolation could result in the risk of double – and possibly multiple – taxation for business. This would have a negative impact on investment, and thus on growth and employment globally."
The Mexican government quickly reacted to this new environment. During the debate of the 2013 tax reform, one of the main discussions was the anti-avoidance measures that the government attempted to introduce. In particular, the tax reform project submitted by the tax authorities to Congress introduced a limitation on payments to foreign related parties that were not taxed abroad or that pay income tax at a rate of less than 22.5%.
After intense discussions, the anti-abuse measures embedded in the tax legislation approved by Congress finished with a more limited scope. Accordingly, the anti-avoidance measures are limited to interest payments, royalties and technical assistance, which are non-deductible when the payment is made to an entity which controls or is controlled by the Mexican taxpayer, provided that the payment is non-existent or non-taxable for the recipient thereof; or when the recipient is a pass through entity if the payment is not arm's-length, in accordance with the provisions of Action 2 described above (double non-taxation). Similarly, payments to related parties in Mexico or abroad that are also deductible by the recipient are non-deductible, unless the latter also recognises such payment as taxable revenues in the same fiscal year or in the next one.
Other actions to address the BEPS challenge can also be found in government's efforts to control the application of double taxation treaties by taxpayers. In this regard, the tax reform establishes that to prevent abusive practices in the application of double tax treaties signed by Mexico, resulting in double non-taxation, the tax authorities may request proof that double taxation would in fact occur in the absence of treaty benefits. An affidavit signed by the taxpayer's legal representative, explaining the rules in the recipient's jurisdiction and providing any relevant documentation would be required to obtain tax treaty benefits.
Another important aspect of the fight against BEPS is the leading role played by the Mexican authorities in their efforts to exchange information between countries. As an example of these efforts, Mexico has signed on as one of the first sponsors of the Convention on Mutual Administrative Assistance in Tax Matters. Another example is that Mexico had requested to join the pilot scheme for the automatic exchange of information. The pilot scheme is an initiative led by the governments of France, Germany, Italy, Spain and the UK aimed at fighting tax evasion. Mexico is the first non-European country to join this scheme. This is an example of the increased coordination among tax authorities suggested by the OECD in Actions 11, 13 and 15, respectively.
Moreover, as the OECD itself develops, the existing Transfer Pricing Guidelines are perceived by some as putting too much emphasis on legal structures (as reflected, for example, in contractual risk allocations) rather than on the underlying reality of the economically integrated group, which may contribute to BEPS. Therefore, the implementation of Actions 8, 9 and 10, basically consists in assuring that transfer pricing outcomes are in line with value creation. The OECD establishes that in the area of transfer pricing, the rules should be improved to add more emphasis on value creation in highly integrated groups, tackling the challenges of valuating and transferring intangible property, allocation of risks, capital and other high-risk transactions that have the potential to shift profits.
Discussions about BEPS are just beginning. Specifically in the area of transfer pricing practice, there are many questions about how it will define and measure the value creation concept. However, we consider it important to analyse the precedents in Mexico involving the discussion of the existence of challenges to the economic substance in certain intercompany transactions. Among the most common issues are the following:
- Recurring operating losses: Recently, Mexico's Tax Administration Service (SAT) has been challenging those taxpayers that have recorded operating losses in several consecutive fiscal years. This is regardless of the methodology applied in the transfer pricing report and the conclusions obtained. While losses may be the outcome to any business enterprise, this approach is particularly challenging for those taxpayers that cannot demonstrate that they operate in highly competitive industries or in cases where the taxpayers cannot prove that those losses are derived from a market cycle, a penetration strategy or any other market-based documented circumstances. Also, it is important that recurring losses are not the result of aggressive planning, mismatched arrangements or tax treaty abuses, as provided in Actions 2, 6 and 12, respectively. In addition, it is noteworthy that the SAT is conducting comparative analyses with other taxpayers in the same industry or geographic region. In these analyses, the tax authority benchmarks the evolution of the profitability of foreign residents of the same economic group against the Mexican entity profitability (local tax authorities use information on the parent's companies from publicly available sources such as global databases, stock market and regulatory filings, and financial media reports.
- Rejection of interest payments: SAT is also challenging those taxpayers that have received loans from foreign related parties while recording a net loss. SAT's technical position is that in these cases an independent lender would not be willing to make a loan to companies with a negative financial history. The conclusion of this position, in line with Action 4, is that such loans are actually capital contributions; therefore, re-characterising the interest payments and arguing that they should be treated as dividend payments.
- Services received from foreign related parties: The tax authorities have increasingly questioned the payments for services received, made by Mexican taxpayers to foreign related parties. Although the most common argument found in examinations (that the payments involved pro rata expenses, allocated by foreign related parties, which are not deductible in Mexico) has diminished as a result of a March 19 Supreme Court ruling, the tax authorities have maintained their strict view in meeting different requirements to allow these deductions, namely:
- Demonstration of effective provision of intragroup services (proof that the services existed in the first place);
- Demonstration that the services received are not duplicative to the taxpayer's own internal activities;
- Demonstration that the payments made do not correspond to shareholders expenses;
- Demonstration that the personnel involved has the knowledge and expertise to provide such services, and
- Demonstration of economic benefits (in the form of increase in revenues or reduction of costs) to the Mexican company as a result of the intercompany service.
It is important to mention that if the taxpayer has a transfer pricing study supporting the intercompany transaction but fails in the documentation of any of the above points it may be subject to a tax adjustment, including the rejection of such payments abroad, all based on domestic rules.
Finally, it should be noted that this issue was recently cited as one of the main points of concern by the tax authorities in Latin America and pointed out in a recent OECD report that analyses BEPS problems in developing countries (Part I of a report to G20 development working group on the impact of BEPS in low income countries).
- Business restructurings: The tax authorities have increasingly been monitoring and auditing intercompany transactions resulting from business restructurings. In a recent announcement, the SAT indicated that it has stepped up its fight against tax base erosion by initiating a review of the Mexican subsidiaries of about 270 multinational entities. The tax authorities have said that the main objective of this review is attempting to identify and challenge companies suspected of using whole or partially sham restructuring arrangements to reduce their tax liabilities in Mexico while maintaining all their business functions and customers in Mexico. This measure can be linked with the OECD's Action 12. In another measure inspired by Action 8, the transfers of intangible property to low tax jurisdictions and payment for services that also involve the use of registered intangibles are operations commonly subject to reviews by the SAT. The compensation for stripped or low risk local distributors resulting from the restructure of former full fledge manufacturers has also been questioned by the SAT.
Next steps: The importance of substance and tax authority challenges
As was mentioned previously, the analysis of economic substance is not new in the current practice of transfer pricing in Mexico. However, the novelty that brings the programme to avoid BEPS is the extension of the substance requirement to other aspects of taxation. The analysis of economic substance requirements seems to be linked to a necessity to gain deeper industry knowledge on the overall aspects of the business operation of the taxpayers. It appears that within the objectives of these activities are mechanisms to identify transactions which would not, or would only very rarely, occur between third parties, much in line with Action 10.
Throughout this article we have identified some of the main challenges facing taxpayers in Mexico as a result of the BEPS Action Plan. However, what are the challenges for the tax authorities?
Usually in the context of a transfer pricing analysis the core and most complex part of the analysis is to fully understand the business and the industry where the taxpayers operate. The OECD analyses in detail the complexity of the current operation of multinational enterprises:
"Global value chains (GVCs), characterised by the fragmentation of production across borders, have become a dominant feature of today's global economy, encompassing emerging as well as developed economie".
However, the Mexican tax authorities (and the same can be applied to other tax authorities' throughout Latin America) lack the necessary industry knowledge, training and other resources to implement in an efficient manner many of the BEPS Action Plan's requirements. Clearly, governments will have to make a significant investment to be able to discuss specifics of the business with taxpayers. The information and data contained in the transfer pricing master file outlined in Action 13, if fully implemented, may at least partially offset these challenges for the tax authorities in the region.
Moreover, in Latin America generally, tax authorities have historically been very focused on detecting transfer pricing issues of form when performing their examinations, sometimes losing focus on the substantive issues. Changing the focus of transfer pricing audits undoubtedly represents an enormous challenge in terms of administrative processes, training, technology, and even cultural change for the tax authorities in the region.
Finally, the OECD, understandably, is currently analysing the problem of BEPS both from the perspective of developed countries and developing ones. Its purpose is to identify the structural differences between these two types of economy, to perform recommendations more accurate. In relation to this, we consider it important to discuss coordination among tax authorities in Latin America and its main trading and investment partners.
Management fee payments, commonly questioned by tax authorities in developing countries as a result of a defence mechanism, are often generated by the request of the tax authority where the costs of providing the centralised services are located. Thus, by the uncoordinated approach that prevails in the world today, a multinational company can be found dealing with multiple audits of the same transaction, with diametrically opposed views of the tax authorities involved. The significant costs of this uncoordinated approach may well be softened by embracing a coordinated approach, which is purposely one of the main goals proposed by the OECD in the reports issued to date.
Lead partner, transfer pricing services, Latin America & the Caribbean Region
Paseo de la Reforma 489, Piso 6
Simón Somohano is a tax partner based in Mexico City and Tijuana responsible for Deloitte's transfer pricing practice in Latin America and the Caribbean Region. He is also a co-leader of the Energy Solutions Center at Deloitte Mexico that provides specialised tax and consulting solutions for companies in the oil, gas and electricity industries.
Under his leadership, Deloitte's transfer pricing practice has been consistently recognised as one of the leading practices in Mexico and Latin America, including 2012 Mexico Transfer Pricing Firm of the Year and 2011 Latin America Transfer Pricing Firm of the Year by the International Tax Review.
He has more than 23 years of experience in the application of tax, economic and financial criteria in transfer pricing, anti-dumping/subsidy investigations, valuation analysis of intangibles, double tax treaty issues, tax planning, business model optimization (BMO), structuring and economic consulting.
He has been consistently named as one of the World's Leading Transfer Pricing Advisers by the prestigious Legal Media/Euromoney Magazine.
His clients include several Fortune 500 multinational companies doing business in Mexico. He has represented numerous companies in the negotiation of advance pricing agreements (APAs) and transfer pricing examinations with Mexican and foreign authorities.
Simón is a frequent guest speaker in international business forums in Mexico and abroad and has authored various articles on transfer pricing. He is also a co-author of Transfer Pricing International Handbook: A Country-by-Country Guide published by the International Tax Institute and Transfer Pricing: A Theoretical, Legal and Practice Framework, published by the Institute of Chartered Accountants (Mexico).
He is a board member of the Transfer Pricing Committee of the Institute of Chartered Accountants (Mexico) and adviser on tax issues to the National Export Maquiladora Council. He has participated as a board member of the Tax Institute at the University of San Diego's School of Law.
He holds an M.Sc. degree in economics and finance from Warwick University's Business School in the UK and a B.Sc. in economics from Universidad Panamericana in Mexico City. He is also a certified financial consultant from Mexico's Securities and Banking Commission.
Transfer pricing partner
Paseo de la Reforma 489, Piso 6
Hernán Katz is partner within the transfer pricing and economic services practice at Deloitte. He is responsible for developing the practice of transfer pricing and economic services in Southeastern Mexico. He has more than 10 years of experience in transfer pricing, financial analysis, economics and valuation. Hernan's clients include prominent companies in the Fortune 500 that do business in Mexico and Latin America. Before joining Deloitte Mexico, Hernán worked for four years at Deloitte's office in Buenos Aires, Argentina.
Hernán has coordinated and directed numerous regional projects of transfer pricing, and therefore possesses an extensive knowledge of the Latin American market and key transfer pricing issues in the region.
Hernan has been involved in numerous planning projects, making complex economic and financial analyses where a significant interaction between transfer pricing and international tax is required.
He has also participated in various audit processes, both in Argentina and Mexico, gaining significant experience in this field.
He has contributed to the following recent articles:
He obtained a B.A. (magna cum laude) degree in economics at the University of Buenos Aires where he also taught courses in macroeconomics and economic policy.