Concepts related to economic substance play a critical role when evaluating operating models and transfer pricing (TP) implications for companies operating in Mexico.
Despite a clear trend for an increased focus of tax authorities on economic substance, there is a lack of clarity and practical guidance for companies in Mexico on the specific metrics to consider when aiming to comply with economic substance requirements.
Subjective terms and requirements may increase uncertainty for evaluations on these matters, thus the development of benchmarking analyses can be a valuable resource to provide insights and support considering trends, regulations and expected controversy around these concepts.
Specifically, starting in 2020 any payments made by Mexican companies to foreign related parties in low tax jurisdictions will be non-deductible unless the recipient of those payments conducts a business activity and demonstrates to have the ‘necessary’ personnel and assets to conduct such business activity.
Furthermore, the recent approval of the subcontracting reform in Mexico prohibiting outsourcing services is requiring several companies to carefully review their operations where the evaluation of functional profiles and economic substance of entities within groups is generally a key component to determine restructuring alternatives.
As to options for companies to evaluate the levels and nature of economic substance on their most significant intercompany transactions, operating models and structures, a comprehensive functional analysis aiming to match the functions performed, assets employed and risks assumed by relevant entities with their corresponding personnel roles and activities should continue to be the starting point of any evaluation along with a detailed review of support documentation.
Nonetheless, due to the lack of guidance on the specific parameters to meet subjective tests such as ‘necessary’ levels of economic substance, the development of benchmarks based on public information and/or market references can be a valuable tool for these evaluations.
In this context, the development of a methodology to evaluate economic substance through specific benchmarking analyses focused on the level of employees and assets for a particular business activity can provide numerical references to validate qualitative findings from functional analyses or expectations for certain business models, such as the fact that certain entities within a group may actually require a relatively low level of personnel or assets to effectively conduct their business activities and still have the proper economic substance.
As an example, potential answers to controversial questions such as how many people would be enough to support economic substance on a company engaged in the leasing of long-term assets exclusively with related parties, or an entity fully dedicated on managing funds among entities in the same group and similarly for other companies with limited functional profiles, could very well be supported to be less than five or ten employees based on the functional analysis, specific facts and circumstances, but the value of reinforcing such findings or positions with robust market data can be significant considering potential examinations from the tax authorities.
With this type of benchmarking analyses on economic substance, and similarly to the application of certain TP methods where benchmarking analyses are fundamental to evaluate compliance with the arm’s length principle, the components for the development of effective benchmarks such as the definition of the methodology, appropriate sources of information, key metrics, comparability factors and application of adjustments may vary depending on the business activity, sector or particular entity being evaluated to estimate reliable results.
Once these results are obtained, the findings for the corresponding levels of personnel and assets generally bring insightful references for discussions and decision making on economic substance matters, while providing strong elements of support which can be incorporated into comprehensive defense files.
Most recent developments such as the discussions on the digitalisation of the economy and BEPS 2.0 initiatives, which could have large impacts on economic substance principles, reinforce the value for companies to perform internal evaluations of their operating models as well as to closely follow the regulations, trends and audits related to economic substance in Mexico.
Considering the current and expected controversy environment, where ‘substance over form’ and ‘show don’t tell’ principles are expected to gain even more relevance, the development of benchmarking analyses can be a valuable resource for these evaluations and a powerful instrument in the face of potential challenges.
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