Tax reforms that came in effect in 2020 and 2021 introduced structural changes to the Mexican tax framework in accordance with the country’s international commitments.
These included substantial changes regarding the tax regime applicable to foreign tax transparent entities or arrangements as well as controlled foreign companies regulations; stringent limitations regarding the deductibility of certain expenses, such as a new earnings-stripping rule; non-deductibility of payments to related parties that are deemed subject to preferential tax regimes or by means of structured arrangements; regulations with respect to hybrid mismatches; and the incorporation of mandatory disclosure obligations.
Although the amendments introduced by the 2022 tax reform might not seem so fundamental, we expect that the practical implications of these on Mexican M&A tax practice will be significant.
This is because the main objectives of the 2022 tax reform are: (i) tackling practices that the regulators have identified as tax loopholes, and (ii) strengthening the legal mechanisms that enable tax authorities to perform audits and collect taxes more efficiently, particularly in respect of cross-border transactions.
This article provides an overview of some of the most relevant amendments to the Mexican Income Tax Law (Ley del Impuesto sobre la Renta, MITL) and Federal Tax Code (Código Fiscal de la Federación), which we expect will have a significant impact on cross-border M&A transactions.
Amendments in respect of debt-funded transactions
Limitations on the applicability of reduced withholding tax rates
Pursuant to the MITL, interest income sourced in Mexico is generally subject to withholding taxes. The withholding tax rates applicable to Mexican-sourced interest income range from 0% to 40% depending on specific characteristics of the transaction, such as the identity and tax regime of the lender and/or the borrower or the nature, terms and conditions of the loan.
In this regard, sections (I) and (II) of Article 166 of the MITL provide reduced withholding tax rates of 10% or even 4.9%, in respect of interest paid on specific transactions, such as cross-border bank loans, capital market financing and interest paid to foreign residents by Mexican financial institutions and Mexican multiple purpose financial entities (Sociedades Financieras de Objeto Múltiple, SOFOMs) that qualify as part of the Mexican financial system.
“Although the amendments introduced by the 2022 tax reform might not seem so fundamental, the practical implications of these on Mexican M&A tax practice will be significant.”
Until December 31 2021, Article 166 of the MITL also provided that a withholding tax rate of 35% would apply to interest payments instead of the reduced withholding tax rates under sections (I) and (II), if the effective beneficiaries (including their related parties) that received more than 5% of the interest paid under the relevant ’securities‘ were (i) persons that own, directly or indirectly, individually or with related parties, 10% of the voting stock of the entity making the corresponding interest payment, or (ii) entities of which 20% or more of the voting stock is owned, directly or indirectly, jointly or severally, by persons related to the paying entity. For such purposes, persons are deemed to be related if one person holds an interest in the business of the other person, both persons have common interests or a third party has an interest in the business or assets of both persons.
A literal construction of this limitation under Article 166 of the MITL, and specifically of the term ‘securities’, led tax practitioners to understand that the restriction only applied to interest payments made under bonds, notes or similar debt-claims that qualified as ’securities’ in the context of capital market transactions. In the M&A tax arena, this interpretation of Article 166 developed into the recurrent use of debt-funded acquisition structures wherein foreign residents would incorporate a Mexican SOFOM for purposes of benefiting from the reduced 4.9% withholding tax rate.
This type of debt-funded acquisition structures remained in use even after the tax authorities issued non-binding criteria pursuant to which they were of the opinion that the limitation on the reduced withholding tax rates under Article 166 of the MITL should be construed in the sense that the restriction is applicable to interest payments between related parties that fall within the scope of the provision and not only in respect of interest paid on ‘securities’ (in the context of capital market transactions). Specifically, the criteria issued by the regulators targeted structures benefiting from the use of SOFOMs.
The 2022 tax reform addressed these structures by clarifying that the limitation under Article 166 was intended to prevent related parties from benefiting from the reduced withholding tax rates in any type of financing transaction and not only in regard to interest paid on securities in the context of capital market transactions. The provision was amended accordingly.
As a result of this amendment, interest paid on any type of financing transaction, including in the context of legitimate cross-border bank loans, would be eligible for the reduced 4.9% withholding tax rate if the effective beneficiaries of 5% or more of the relevant interest income (including its related parties) are: (i) persons that own, directly or indirectly, individually or with related parties, 10% of the voting stock of the entity making the corresponding interest payment, or (ii) entities of which 20% or more of the voting stock is owned, directly or indirectly, jointly or severally, by persons related to the paying entity.
In accordance with thin capitalisation rules under the MITL, the debt-to-net equity ratio allowed for Mexican entities is 3:1, though some exceptions apply. Interest paid in excess of that ratio would be considered as non-deductible for income tax purposes.
Article 28(XXVII) of the MITL provides certain exceptions in respect of which thin capitalisation rules are not applicable. In accordance with the provision in effect until December 31 2021, thin capitalisation rules did not apply to debts contracted by taxpayers deemed to be part of the Mexican financial system for purposes of the performance of their corporate purpose, as well as to those contracted for the construction, operation and maintenance of infrastructure in strategic industries or the generation of power.
The broad terms in which the exception to thin capitalisation rules was originally drafted led to two specific constructions of the provision: (i) that any taxpayer deemed to be part of the Mexican financial system could qualify for the exemption, including non-regulated SOFOMs, and (ii) that taxpayers whose activities were intertwined with the construction, operation and maintenance of infrastructure in strategic industries or the generation of power could also qualify for the exemption, even if they were not directly performing such activities.
These interpretations were identified as tax loopholes by the 2022 tax reform and amended to limit the applicability of the thin capitalisation exemptions. In particular, the relevant provision was amended to reflect that:
a) Non-regulated SOFOMs whose core activities are performed with related parties will no longer be considered exempt from thin capitalisation rules on the grounds that the use of such entities had led to abusive tax practices wherein multinational groups would incorporate a Mexican non-regulated SOFOM to benefit from both a reduced withholding tax rate as well as the exemption on thin capitalisation rules, and
b) Only taxpayers with a concession, permit or direct agreement evidencing that they will perform on their own the activities relating to the construction, operation or maintenance of infrastructure in strategic industries or for the generation of power would qualify for the exemption.
Taxation of capital gains derived from transfer of Mexican shares
Income tax due on Mexican-sourced items of income derived by foreign tax residents is generally levied by withholding on the gross proceeds, with the Mexican party of the transaction acting as withholding agent. However, under specific circumstances, foreign tax residents are allowed to pay income tax on a net basis.
With respect to the transfer of shares issued by a Mexican entity, under domestic law, foreign residents are normally entitled to pay income tax either at a 25% rate on the purchase price or, subject to complying with certain requirements, at a 35% rate on their actual capital gain.
Prior to the enactment of the 2022 tax reform, the main conditions under domestic law that needed to be satisfied for a foreign resident to be entitled to pay income tax on a net basis were (i) appointing a legal representative in Mexico specifically for the purposes of complying with the principal’s tax obligations, and (ii) filing a tax report issued by a certified public accountant assessing the corresponding tax basis.
However, as of January 1 2022, in addition to these conditions, legal representatives appointed by foreign residents will now be required to show that: (i) they have voluntarily assumed a joint liability in respect of the tax liability of their principal; and (ii) they have the resources needed to cover any such tax liability, either with their own assets or by having the authority to dispose of certain assets of the principal effectively acting as collateral.
As a result, legal representatives will now be required to satisfy additional requirements as well as to comply with specific filing obligations. Failure to do so could result in a challenge by the tax authorities to the principal’s election to pay income tax on a net basis.
The tax reform justified the need to include these additional filing obligations on the ground that foreign residents often appointed legal representatives that did not comply with their own formal tax obligations, challenged the existence of a joint liability in respect of their principal’s joint liability or simply did not have the solvency to cover for the tax liability with respect to which they were held to be jointly liable.
Unfortunately, because of these amendments and the ambiguous secondary legislation enacted for purposes of its implementation, costs in connection with such designations are likely to increase significantly, in terms of both the corporate documentation that will now be needed and fees charged by third parties involved in the process (e.g., notaries, advisers and service providers).
Furthermore, due to the liability to which legal representatives will now be exposed, small cap companies or foreign residents without a presence in Mexico are likely to struggle to successfully comply with the conditions needed for them to be entitled to pay Mexican capital gain tax on a net basis.
Joint liability under the Federal Tax Code
Under the 2022 tax reform, several amendments were made to Article 26 of the Federal Tax Code in connection with the scenarios under which the taxing authorities may claim a joint liability. Some of the most important amendments, in addition to the joint liability to which legal representatives of foreign residents may be subject, are:
a) Mexican entities whose shares are transferred by a foreign seller to a foreign buyer will now be required to file a notice with the tax authorities within 30 business days of the date on which the relevant transfer occurs. Failing to comply with this filing obligation would result in the Mexican target company being open to joint liability in respect of the seller’s taxes arising from the transaction.
b) Prior to the 2022 tax reform, article 26 of the Federal Tax Code provided that the acquirer of an ongoing business could be held jointly liable for unpaid taxes attributed to the acquired business. However, the corresponding provision did not define how the term ‘ongoing business’ should be construed. Accordingly, the relevant provision was amended to include specific scenarios under which taxing authorities may presume that an ongoing business has been transferred. This amendment is particularly relevant in the context of asset deals.
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Federico Scheffler is a partner at Galicia Abogados. He specialises in tax consultancy, in particular M&A transactions, venture capital, corporate and project finance and capital markets.
Federico started his professional career in corporate law and M&A. After several years as an M&A practitioner, his interest in the tax component led to specialisation in tax law. This gives him a unique profile, enabling him to participate in the M&A process in collaboration with the other practice areas involved.
Federico has a bachelor’s degree in law from Instituto Tecnológico Autónomo de México and a specialisation in tax law from Universidad Panamericana. He also obtained an Executive MBA from the Instituto Panamericano de Alta Dirección de Empresa.
T: +52 55 5540 9200
Sebastián Ayza is a senior associate at Galicia Abogados. He specialises in corporate reorganisations, M&A and national and cross-border investment fund structuring, mainly concerning private equity and real estate transactions.
Sebastián joined the tax practice of Galicia Abogados in 2018. His work focuses on transactional tax matters.
Sebastián studied law at Instituto Tecnológico Autónomo de México. From 2013 to 2018 he worked at SMPS Legal in the transactional tax and tax litigation practice areas.
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