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back to index backLATINtalk March,  2005

Congress approves 2005 tax reform

The Mexican Congress recently approved a tax reform that increases the administrative burden and effective tax rates of both resident and nonresident taxpayers. The reform measures entered into force on 1 January 2005.

Tax Rate

The corporate tax rate is reduced to 30% in 2005, 29% in 2006 and 28% thereafter.

Indirect Foreign Tax Credit

Under the new provisions, income tax paid by a nonresident company that distributes dividends to another nonresident company, which, in turn, distributes dividends to a Mexican corporation, may be credited against the Mexican corporation's income tax liability provided the following conditions are satisfied:

  • The dividend and the income tax are accrued by the Mexican corporation
  • The Mexican corporation owns at least 10% of the first tier company;
  • The first tier company owns at least 10% of the second tier company;
  • The minimum combined ownership in the second tier company is 5%; and
  • The Mexican government has concluded a broad exchange of information agreement with the country where the second tier company is resident.

Consolidated Tax Return

As of fiscal year 2005, companies that are part of a group may consolidate 100% of their profits/losses rather than just 60%. The tax reform also includes specific rules applicable to the computation of asset tax, as well as temporary regulations incorporating a transition mechanism that allows taxpayers to move from the 60% consolidation scheme into the new 100% consolidation rules.

One feature of the reform is that taxpayers must disclose in the tax report issued by an independent public accountant the amount of income tax that has been deferred as a result of electing to file a consolidated tax return. The provision regulating the disclosure is not clear on what exactly must be reported, as there are different interpretations of the appropriate procedure to be followed for quantification purposes. Failure to disclose the information, however, will result in de-consolidation of the group.

Thin Capitalization Rules

Thin capitalization rules have been introduced to prevent companies from using debt as a way to distribute profits to shareholders. Beginning in 2005, interest paid on cash loans granted by related parties in excess of three times stockholders' equity may not be deducted. The capitalization rules are not applicable to taxpayers that obtain a ruling from the tax authorities, or to financial institutions.

The restriction on the interest deduction applies to interest on debts held by the taxpayer with nonresident independent parties, provided the Mexican taxpayer has one related party. For example, a Mexican corporation with a sister company that has obtained a loan from an unrelated foreign bank would be subject to the thin capitalization rules if its debt-to-equity ratio exceeds 3:1. This reform apparently targets back-to-back loans used by Mexican corporations; however, in our opinion, it only reflects the fact that the Tax Administration Service has not been able to counteract the use of such loans with existing rules in the Mexican Income Tax Law (ITL).

Under a transition rule, taxpayers that determine that their debt-to-equity ratio exceeds 3:1 when the new law enters into effect have five years from 1 January 2005 to reduce such debts proportionately in equal parts in each of the five fiscal years until they reach the 3:1 ratio. If the taxpayer's debt to-equity ratio exceeds 3:1 at the end of this period, any interest paid on the debt exceeding the limit as of 1 January 2005 will not be deductible.

Preferential Tax Regimes

The rules governing investments in preferential tax regimes have been amended. Currently, a "black list" of countries is used to determine whether an investment is deemed to be in a low-tax jurisdiction. Under the reform, if foreign-source income is not subject to tax abroad or if it is subject to an income tax that is less than 75% of the income tax computed under Mexican tax legislation, the investment will be deemed to be in a low-tax jurisdiction. It is possible under the new rules that a country not typically classified as a tax haven might fall under the less-than-75% rule.

Under the ITL, passive income (i.e. dividends, interest, royalties and capital gains) derived directly or indirectly by a Mexican resident through a branch, entity or any other legal entity located in a preferential tax regime, will be subject to taxation in Mexico in the year the income is derived.

Taxpayers earning income from a preferential tax regime must file an information return in February of each year. Failure to file the return is subject to a penalty that ranges between three months and three years imprisonment.

Nonresidents with Mexican-Source Income

As a general rule, income from services provided outside Mexico is not taxed as Mexican-source income. A new presumption is added to the ITL that would deem income to be Mexican-source income (unless demonstrated otherwise) when a resident in Mexico, or nonresident with a PE in Mexico, makes payments to a nonresident related party. Thus, the burden of proof is shifted to the payor who will have to maintain supporting documentation evidencing that the service was actually rendered outside Mexico.

Another significant change made by the reform is that certain income will be deemed to be excluded from the definition of business income. The purpose of this amendment is to tax as Mexican-source income several types of income (e.g. technical assistance and management fees) that clearly would not be taxed under Mexico's tax treaties because the income would be categorized as business income subject to taxation only if the nonresident has a PE in Mexico.

This amendment is a part of a series of tax reforms proposed by the Executive Branch and approved by the Mexican Congress to override tax treaties. According to the Mexican Constitution, treaties have a higher legal hierarchy than local legislation. In addition, Mexico is part of the Vienna Convention that requires treaties to be interpreted on a good faith basis. Therefore, a correct interpretation of tax treaties should not result in the withholding of tax for classes of income that cannot be taxed in the source country unless the nonresident has a PE. Nevertheless, it can be expected that the Tax Administration Service will try imposing withholding tax on particular classes of income, such as management fees.

Source: Deloitte Mexico City - GAI

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