The Mexican tax authorities have been facing important challenges in their quest to effectively apply taxes that relate to the technology industry. The complexity of the industry has led the Mexican government to draft several proposals to enact unilateral measures while the OECD reaches a consensus as to how to tax technology companies without a presence in Mexico. Tax policy authorities and lawmakers in Mexico were, at the time of writing, still analysing these proposals.
Transactions in connection with the licensing and use of software are a key tax focus within the tech sector. The Mexican tax authorities have shown themselves to be more determined and aggressive than usual when it comes to the characterisation of payments related to software, a recurrent issue for several years because of its complexity. This can be observed particularly in the guidance that the Tax Administration Service (SAT) issued to define the term 'standardised software' for the purposes of Article 12 of double taxation treaties (DTT) signed by Mexico. The definition has complex implications for taxpayers.
Pursuant to Article 15-B of the Federal Fiscal Code, royalties should include, among other elements, payments of any kind for the temporary use or enjoyment of copyrights to literary, artistic or scientific works, including copyrights to computer programs or sets of instructions (software) required for the operating of programmes or carrying out of application tasks, regardless of the medium on which they are transferred. Therefore, based on the provisions of Article 15-B of the Code, it may be concluded that payments made for software should be classified as royalties.
Accordingly, while the Federal Fiscal Code provides the definition of the term 'royalties', special laws must be taken into account to determine the tax treatment applicable to the respective payments, specifically in the case of payments made by a Mexican resident to a non-resident. Therefore, in relation to royalty payments, Article 167 of the Mexican Income Tax Law states that when the property or rights for which the royalties paid are used in Mexico, or when the royalty payments are made by a resident in national territory or a non-resident with a permanent establishment in the country, the income source will be viewed as Mexican. Consequently, payments made for software that fall within the above-mentioned description are subject to a 25% withholding tax on the total amount of royalties paid.
One must refer to the DTTs signed by Mexico to determine whether a preferential withholding tax rate may be applicable. However, tax treaties should be interpreted in light of the Commentaries of the OECD on the Model Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion (commentaries).
The commentaries on Article 12 relating to royalties of the model treaty provide an explanation for the meaning of the term 'royalties' and cases where payments between residents of contracting states should be deemed royalties. This will determine whether such payments should be subject to withholding tax under Article 12 or to the treatment provided for in Article 7 related to business profits.
For example, based on the commentaries, the OECD considers that payments made by a software distributor to another owner of the intellectual property rights to the software, as consideration for the right to market it, should not be construed as royalties because the software is being distributed without being entitled to exploit any copyright with respect to it. In the OECD's opinion, this is the case regardless of the fact that the software is subject to minor modifications or customisation for purposes of installation by the user or client.
However, Mexico, along with Spain and Portugal, made an observation related to paragraphs concerning software in Article 12 of the commentaries. The observation anticipates that software payments could be characterised as royalty payments where: "payments are in consideration for the right to use a copyright on software for commercial exploitation (except payments for the right to distribute standardised software copies, not comprising the right neither to customise nor to reproduce them) or if they relate to software acquired for the business use of the purchaser, when, in this last case, the software is not absolutely standardised but somehow adapted to the purchaser."
Accordingly, the observation signals that the SAT would characterise payments for the use of software as royalty payments unless the payments are for 'absolutely standardised' software, regardless of whether or not a copyright is being granted. The question then arises on what should be understood as being 'standardised software'.
Striving for clarity
Following the OECD observation by Mexico, Spain and Portugal, the SAT issued guidance to define the term 'standardised software' for the purposes of Article 12 of DTTs signed by Mexico. Pursuant to administrative rule 2.1.37., the term 'standardised application' is defined as the application to which use or enjoyment is granted homogeneously and massively in the commercial marketplace to any person. This is commonly known as: commercial off-the-shelf (COTS).
Furthermore, the rule states that standardised or standard application does not include an application which is special or specific. For these purposes, the rule poses two hypotheses to illustrate when the software would be considered special or specific. The first is "when the application is customised in some way". The rule adds that "it is considered that an application is customised in some way when the source code is modified in any way…".
However, the rule has been modified by the SAT on several occasions, causing uncertainty about the precise position of Mexico in this regard. One of the latest modifications was to remove from the definition of 'special or specific application' the phrase relating to source code modifications. This amendment causes confusion on what should be deemed as 'standardised software' for purposes of applying Article 12 of the DTTs, since now the definition is broadened and many payments that were not considered royalty payments may now fall within the scope of such definition.
In general terms, the wording of the rule has never been clear. The examples all fall short when determining whether withholding tax should be applicable or not in the many cases in which software payments may be considered payments for customised or standardised software.
Therefore, given the aggressive position of the SAT reflected in the above-mentioned rule, a careful analysis must be made on a case-by-case basis of transactions involving the licensing or use of software in Mexico. The agreements must be thoroughly reviewed in order to determine which rights are being granted to the beneficiary of the software, whether the software is used for the business of the acquirer or for commercial exploitation and whether we may conclude that only services are being rendered through the software with no copyrights being granted.
This analysis becomes essential in determining whether a withholding is applicable in Mexico in light of domestic legislation and guidance coupled with the DTTs and other international provisions.
|Luis Adrián Jimenez-Robles|
Luis Adrian Jimenez serves as a partner in the firm's tax practice group. He joined the firm in 2004 and advises clients from a range of different industries. Luis also focuses on Mexican inbound planning for North American and European headquartered multinationals and multi-jurisdictional group reorganisations and restructurings. He is both a CPA and a lawyer.
Luis focuses his practice on general Mexican tax consulting for all types of companies and transactions. He is specialised in tax consultancy for international transactions and advice to Mexican companies that are subsidiaries of transnational groups. He also has experience in all kinds of tax matters related to mergers and acquisitions, as well as in reorganisations and restructurings.
Given his accounting, tax and legal background, Luis leads several tax compliance projects and actively participates in litigation projects. He is a member of the Mexican Association of Public Accountants. He studied as a public accountant at the Escuela Bancaria y Comercial, completed specialised studies in tax matters at the Instituto Tecnológico Autónomo de México and obtained his LD at the Universidad Tecnológica de México.