Mexico's federal government, in compliance with a constitutional mandate, on September 8 2013 presented to the Congress a proposed economic package for fiscal year 2014. The government's economic package contains a tax reform initiative for consideration by Mexico's Congress. One of the main axes of the tax reform initiative was the amendment proposals regarding consumption taxes: VAT and excise duties.
The objective of this article is describing the reasons that have motivated the proposals of change that impact to consumption taxes that should be discussed, debated and approved by the Mexican Congress during the following weeks.
The environment of the tax reform
As indicated by the OECD in its latest economic study of Mexico published in May 2013, the Mexican tax system is based on a very tight taxable base and a weakness in fiscal revenues in relation to other countries, although the tax rates are not very different from those that apply to them. The OECD points out as causes of the above, in the first place, the prevalence of tax expenditures (tax benefits/allowances) applicable to the corporate income, personal income and consumption tax systems, which account for an estimated 3.1% of GDP or around 16% of the actual government revenues. In second place, it refers to the high levels of tax evasion arising from the informal economy.
Regarding VAT, the OECD criticised the high level of tax expenditures, in the form of exemptions and zero rates of VAT applicable in Mexico, a fact which, combined with high levels of tax evasion, determined that Mexico is the OECD member with the lowest VAT efficiency ratio that is an indicator of VAT collection efficiency.
Among the factors that negatively impact VAT in terms of tax revenue, and lower tax revenue by around 1.5% of GDP, the OECD report mentions the zero rate applicable to foodstuff and medicines, the reduced rate of 11% applicable to the transactions carried out in the border area and exemptions applicable in medical and educational services.
Likewise, the OECD makes recommendations to change the Mexican VAT system in a future tax reform in Mexico. Among them, it proposes the removal of the reduced rate of 11% and the lack of VAT payment on temporary imports by an entity applying the special IMMEX/maquiladora industry regimes. In addition, the OECD is in favour of re-examining the list of products that are applicable for exemptions or zero rates, understanding that social purposes intended to meet with these measures could be better served through direct transfers.
In the first part of the statement of reasons justifying the initiative decree, which among other things, proposed changes in VAT and excise taxes, the Mexican government appears to assume the thesis of the OECD report regarding the poor levels of VAT collection efficiency in Mexico, reminding that they are significantly lower than the applicable ones in their OECD partners and other Latin American countries. However, as will be discussed, despite considering in part the OECD thesis, certain proposals of the tax initiative reform in relation to VAT have not been free of controversy.
VAT on foods and medicines
The application of the VAT zero rating to foods and medicines is considered one of the main causes of the erosion of the tax base of VAT in Mexico. However, its removal or modification has been one of the main arguments raised for more than a decade in the Mexican tax landscape. The implementation of the general VAT of 16% on foods and medicines is a topic that has been involved in political controversy between supporters of the zero rate on these products and those who, for various reasons, argue that both disposals should be levied at the standard VAT rate, that is 16%. It should be noted that the debate on this issue was intensified in Mexico during the months preceding the presentation of the tax reform initiative.
KPMG Mexico's indirect tax practice performed a comparative analysis that was published in July 2013. According to the conclusions, the application of an effective consumption tax rate, that is a VAT rate different to the zero rate, on foods and medicines is a global trend.
The study verified the tax treatment applicable to the deliveries of these items in force in 75 countries that apply VAT or similar indirect taxes. The conclusions of our comparative analysis were:
- In the case of food, 66% of countries levy such products applying a VAT rate different from the zero rate, and being 68% for the case of medicines.
- In the case of the countries in which food and medicines are taxed at a reduced VAT rate, the percentages are 41% and 40%, respectively. The average reduced VAT rate applicable is 9% in the case of food and 7% in the case of medicines.
- The above conclusions are more evident if we consider certain regions such as Europe where 66% of the countries analysed in that area apply a reduced rate on foodstuff, being the percentage of 72% in the case of medicines. In this group of countries, the average reduced rate applicable is also 9% in the case of food and 7% in the case of medicines.
- The trend is not affected if we take as a sample OECD countries, where 58% of these taxed food at a reduced rate, being the percentage of 55% in the case of medicines. In this group of countries, the average reduced rate applicable to these products is at 9% for food and 7% in the case of medicines.
As noted in the conclusions of the analysis, many countries have implemented a reduced VAT rate that aims to promote the tax treatment of the disposal of products that can have social impact. But finally, and perhaps for other political reasons, the Mexican government's decision has been not to include the elimination of the zero rate, presently applicable to food and medicines in the proposed reform, instead resorting to other proposals to improve tax collection capacity.
Tax reform proposals on consumption taxes
Firstly, it proposed the removal of the VAT preferential tax rate of 11% applicable to transactions carried out in the border area, which is a strip of Mexican territory which comprises areas of states close to their external borders. The elimination of this preferential tax is because of the disappearance of the circumstances that justified it when it was approved through a decree in 1979. This measure is considered logical and was, from a certain point of view, expected.
Secondly, it proposed the removal of several tax benefits applicable to owners of foreign trade programmes such as the IMMEX (including maquiladoras), the automotive sector companies holding a tax warehouse, bonded warehouse and the strategic bonded warehouse. Among the measures whose abolition is proposed are the following:
- The VAT exemption on temporary imports of goods, of the entities operating under the above-mentioned programmes, which are returned abroad once processed or transformed. The approval of this measure would imply a negative financial impact for maquiladoras entities as they would have to recover the VAT they should pay for imports.
- The exemptions applicable to companies resident abroad when transmitting goods in the Mexican territory benefiting from the aforementioned trade programmes to another non-resident company or to a Mexican entity applying one of these programmes. In this case, in general, the lack of definition by the tax authority of rules for non-resident companies to tax such transactions between non-established parties in Mexican VAT and the application of the VAT withholding by Mexican purchasers are elements that would complicate taxation of these operations and undermine tax neutrality to them.
- The withholding VAT applied by entities under the IMMEX programme or automotive companies on acquisitions of goods from local suppliers. In this case, deduction of the withholding in the same period in which it is declared produces a financial benefit to these entities that would disappear if this measure is approved.
- The VAT exemption on the sale of goods made in strategic bonded warehouses. In this case, the approval of these measures, together with the abovementioned ones, would challenge the viability of this type of warehouse.
Thirdly, several relevant exemptions in Mexico's economy are abolished:
- Sales of housing real estate
- Lease of housing real estate.
- Fees and interest on mortgage loans for housing purchases.
- Educational services.
In this case, such proposals, jointly with the limitation of the scope of the exemption on public ground transportation for people to urban, suburban and metropolitan transportation, were justified in a tax progressivity principle that questions such exemptions on the fact that they benefit wealthy people, when their removal, if approved, would actually have a direct impact on middle class people who perform or acquire such property or services.
Fourthly, a positive measure such as the homologation of the VAT treatment of the services of air cargo transportation with that applicable to the passenger transportation, a circumstance that would improve the VAT recovery regime of VAT incurred by freight transport companies in the provision of air transport services. Also, the proposals look to eliminate the VAT zero rating on bubble gum sales, pets and its processed foods, gold and other objects that could be described as luxury and the provision of accommodation and related services to foreign tourists participating in certain events.
Finally, on the tax reform proposals with respect to excises taxes, we would like to highlight the following:
- The increase of the tax rates applicable to the excise tax applicable to beer and alcoholic beverages.
- Another proposal would repeal the excise taxes exemption available with respect to the temporary imports of goods, sales by foreign residents to IMMEX/maquila entities and the deliveries of goods kept in strategic bonded storage facilities, a change that would negatively affect these types of transactions.
- There is a proposal that would impose an excise tax of MXN1 ($0.079) per litre for drinks flavouring, concentrates, powders, syrups, essences or flavour extracts, containing any type of added sugars.
- Additionally, two new environmental taxes have been proposed: one a carbon tax looking to place a levy on the use of fossil fuels and induce a further reduction of the carbon dioxide emissions and another one levying the sale or imports of pesticides, that would be taxed at rates that range from 6% to 9%, depending on their level of toxicity.
The low level of VAT collection effectiveness, stated by the OECD in its economic survey of Mexico for 2013, makes the VAT efficiency ratio of Mexico the lowest of the OECD countries in terms of VAT collection because of several benefits and special regimes existing in this tax.
However, despite acknowledging, apparently, the OECD's position in its statement of reasons, it is understood that the Federal Executive, has only partly followed the indications of the OECD in its initiative of tax reform. It is doubtful that, in case of approval, any of the proposed measures would help in improving the VAT collection efficiency ratios in Mexico and be as efficient from a tax collection point of view as the application of an effective VAT rate (even reduced) on food and medicines would have been. The legislative discussion of the initiative of VAT and excise taxes reform within the framework of the general initiative of tax reform promise to be interesting given the limited enthusiasm that has been awakened by some of the indirect tax reform proposals and the actions of many business associations whose interests could be impaired if the reform is approved in the terms proposed.
César Catalan is a tax partner and head of the indirect tax practice with KPMG in Mexico. César has more than 18 years' experience in domestic and international tax issues with a focus on tax planning and compliance, restructuring, outbound and inbound investments, due diligence, obtaining rulings from the authorities, recurrent compliance preparation and reviewing work; every time focused on business and tax efficiency.
After many years with other firms, César joined KPMG in Mexico in 2004 and became a tax partner in 2005. For five years he was in charge of the human resources strategy for the tax practice, and was appointed to start the indirect tax practice – the first of its kind in Mexico. He is also a member of KPMG in Mexico's infrastructure practice and part of the managing partners group for KPMG in Central America.
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