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back to index backLATINtalk March,  2006

Mexico: Consequences of 2005 Tax Reform and Expectations for 2006

The thin capitalization rules included in the 2005 tax reform have been subject to criticism because of their broad application to unrelated party transactions, poor drafting and general lack of clarity. Taxpayers face formidable challenges in ensuring compliance with the rules at the end of fiscal year 2005.

Under the new rules, interest payments made on specific kinds of debt may not be deducted for tax purposes if the debt-to-equity ratio exceeds 3:1. Restricted interest in this context is interest paid on loans granted by related parties (whether in Mexico or abroad) and on loans granted by unrelated parties resident outside Mexico.

In the case of related party loans and loans granted by unrelated parties resident abroad, the 3:1 debt-to-equity ratio will not apply (and hence, can be exceeded) if the taxpayer obtains a favorable transfer pricing ruling from the competent authorities confirming that the price in the transaction is similar to a price that would have been agreed on by independent parties in similar circumstances, as well as a CPA opinion on the transfer pricing methodology. While we have not seen any specific cases, this procedure is expected to give rise to complications for both taxpayers and the tax authorities, because it does not establish an objective criterion (such as the interest rate) but rather establishes a criterion that depends on the taxpayer's ability to provide evidence that the terms of the loan arrangement are reasonable from a market perspective.

Another issue that has caused concern among taxpayers and that remains unresolved is the application of a transitional rule. According to the transitional rule, taxpayers whose debt-to-equity ratio exceeds 3:1 at the time the rules became effective (i.e. 1 January 2005) have five years from that date to decrease such debts proportionately in equal parts to comply with the ratio. If at the end of five years, the taxpayer's debt-to-equity still exceeds 3:1, any interest due during any of the prior five years will be nondeductible. Taxpayers need guidance on the transitional rule because, practically speaking, it is not possible to decrease a debt in equal parts for business reasons. Further, the fact that the thin capitalization rules are not applicable to certain regulated taxpayers in the financial sector has generated criticism because there is no rationale for this exception.

Although the Mexican tax authorities may decide to postpone the effective date of the thin capitalization rules until 2006, to date, no guidance has been issued to clarify the application of the rules. It is hoped that the authorities will acknowledge the difficulties of applying the rules during this first year of implementation and issue guidance as soon as possible.

Reform Expectations for 2006

In September 2005, the Executive Branch sent Congress the 2006 Economic Package. The package includes only a few tax reforms, but these proposals would significantly affect corporate taxpayers.

The most notable measure included in the 2006 package is the proposed introduction of the substance-over-form principle. If approved, the tax authorities would be authorized to determine whether a taxpayer has engaged in artificial or improper transactions (individually or in the aggregate); if the taxpayer has so engaged, the tax authorities would be able to recharacterize the transactions and assess any relevant taxes. The tax authorities would be allowed to conclude that a transaction is artificial or improper if:
• An actual or proper transaction would have equal or similar economic effects; or
• The effect of the transaction is to reduce the tax base or payment of tax, or to cause a tax loss or tax incentive or benefit to exceed that which would have been generated in normal conditions.

The proposal also provides for the creation of an advisory committee that would determine whether an artificial or improper transaction exists.

As proposed, the substance-over-form measure would give rise to considerable uncertainty because the tax authorities would no longer be considering transactions by applying the law, but according to subjective and hypothetical opinions of committee members, who would have authority to conclude what might have happened in a particular transaction. The proposed measure has been sharply criticized by the business community, and it is hoped that lawmakers will address the shortcomings of the proposal during the debate on the economic package.

Other proposed reforms are included in the 2006 package, including the imposition of joint and several liability of tax advisors and the introduction of independence rules for audit firms that issue special reports for tax purposes.

Source: Galaz Yamazaki Ruiz Urquiza - GAI

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