Mexico’s lawmakers were busy at the end of 2004, adopting a series of new laws and taxes that became effective Jan. 1, 2005. The following reports were provided by Deloitte & Touche Mexico and by Baker & McKenzie. The first report summarizes tax reform and is from Deloitte & Touche Mexico.  

Tax rate

      The corporate tax rate will be reduced from 33 percent to 30 percent in 2005, to 29 percent in 2006 and 28 percent thereafter.

      Under the reform, 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 percent of the first tier company.

      •The first tier company owns at least 10 percent of the second tier company.

      •The minimum combined ownership in the second tier company is 5 percent.

      •The Mexican government has concluded a broad exchange of information agreement with the country where the second tier company is resident.

Thin capitalization rules

      Thin capitalization rules will be introduced to prevent companies from using debt as a way to distribute profits to shareholders. Beginning in 2005, interest paid on loans granted in cash by related parties in excess of three times stockholders’ equity may not be deducted. The capitalization rules will not be applicable, however, to taxpayers who obtain an advance pricing agreement (APA) from the tax authorities, or from financial institutions.

      The restriction on the interest deduction will apply 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. Apparently, the intention of this reform is to attack back-to-back loans used by Mexican corporations. In our opinion, this only reflects the fact that the Tax Administration Service has not been able to counteract the use of back-to-back loans with existing rules in the Mexican Income Tax Law (ITL).

      The interest deduction restriction clearly violates the nondiscrimination rules in Mexico’s tax treaties. Under this scenario, the thin capitalization rules will not be applicable to taxpayers who obtain an APA that confirms that the taxpayer has obtained an arm’s length profit (i.e., a profit computed under the transactional net margin method, the profit split method or the residual profit method) in its dealings with other related parties. The APA request must be accompanied by a report issued by a certified public accountant, containing a transfer pricing methodology as prescribed in the Mexican ITL.

      Under a transition rule, taxpayers who determine that their debt-to-equity ratio exceeds 3:1 when the new law enters into effect, will have five years from Jan. 1, 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 earned on the debt exceeding the limit as of Jan. 1, 2005 will not be deductible.

Preferential tax regimes

      The rules governing investments in preferential tax regimes have been amended. Currently, a blacklist 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 taxation abroad or if it is subject to an income tax that is less than 75 percent 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 that is not typically classified as a tax haven might fall under the less-than-75 percent 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 in which the income is derived. Specific rules are included to permit non-taxation of active income under certain circumstances.

      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.

Consolidated tax return

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

      One aspect of the amendments to the consolidation regime 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 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 this information will result in a deconsolidation of the group.

Nonresidents with Mexican-source income

      As a general rule, services provided outside Mexico are 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 payer 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.

Mexico tax alert

      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. Based on 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 services.

Profit sharing

      The Mexican Constitution requires employers to share with their employees 10 percent of their taxable profits (accruable income less deductions) without reducing carry forward losses. Under the tax reform and beginning in 2006, profit sharing paid to employees may be reduced from taxable profits or may increase carry forward losses. Under a temporary provision, during 2005, 80 percent of the excess of profit sharing over tax-exempt fringe benefits paid to employees may be reduced from taxable profits or carry forward losses.

Deduction for cost of goods sold

      As of Jan. 1, 2005, the cost of goods sold, rather than the cost of acquisition, may be deducted. According to the government, the deduction for acquisition costs was justifiable during inflationary periods; however, under single-digit inflation, that deduction can no longer be justified.

      Transition rules have been established for the taxation of the 2004 inventory ending balance (Dec. 31, 2004), which has already been deducted under the 2004 law. Such rules establish a procedure to determine an average inventory turnover of the taxpayer for the last three fiscal years, and depending on that, identify whether proportional taxation will need to be made within a range of four to 12 years.

Asset Tax

      In accordance with the recent decision of the Mexican Supreme Court, which declared Article 5 of the Asset Tax Law unconstitutional because it denied the deduction of debts incurred with nonresident companies for purposes of determining the asset tax base, Congress approved an amendment to that article allowing for such deductions.

Amendments to the Sectoral Promotion Programs

      On Dec. 2, 2004, the Ministry of the Economy (“SECON”) published in the Federal Official Gazette amendments to the Decree that Establishes Several Sectoral Promotion Programs (PROSEC Decree). The following summary was prepared by Bake & McKenzie.

      Among the reasons for these amendments are promoting the development of products with greater value added and strengthen the competitiveness of certain productive chains, to benefit the consumer with lower prices, strengthen domestic markets and increase exports.

      The amendments include the reduction of duty rates for certain imported goods, as well as additions and eliminations of finished products and imported goods. In this regard, the following sectors were modified: electronic; furniture; toys; footwear; capital goods; photographic; diverse industries; chemical; rubber and plastic; steel; leather & furs; automotive industry; and textile and apparel.

    Regarding the reduction of duty rates for certain imported goods, most of them were applied to goods listed under the footwear and textile and apparel sectors. Most of the materials that were eliminated from the Decree affected goods listed under the toys and footwear sectors.

      Be advised that the eliminations of imported goods will become effective 180 calendar days following the date of the publication of these amendments. All other provisions established under this publication, became effective on the day following publication.

      Should the PROSEC Decree and its amendments not allow your company to benefit from the preferential duty rates established therein, you should be aware that there are certain procedures that may be followed to request the inclusion of goods in the Decree, or, to import goods with preferential duty rates through Rule 8 import permits in accordance with the Mexican General Import and Export Duty Law.

Maquila benefits

      As you may know, a Decree granting several tax benefits to the taxpayers indicated therein was published in the Federal Official Gazette on Oct. 30, 2003. This Decree grants some benefits to the Export Maquiladora Industry; specifically, Article 11 establishes that those maquila companies referred to in article 2 of the Mexican Income Tax Law may reduce the payment of income tax in an amount equal to the difference of Income Tax resulting from calculating the income under the Safe Harbor option (the larger of 6.9 percent ROA and 6.5 percent over costs and expenses) and the calculation of Safe Harbor at a rate of 3 percent (the larger of 3 percent ROA and 3 percent over costs and expenses), provided that the requirements set forth in article 216-Bis of the ITL have been met.

      This income tax reduction for the year 2003 was calculated in accordance with Transitory Article Four of the Decree, proportionately to the number of days during which the Decree was in effect during that year, that is, almost 17 percent. However, there were several interpretations regarding the application of the Decree for the year 2004 and thereafter. Some sustained that the benefits of such Decree were not applicable after 2003, while others indicated that the benefits thereof were 100 percent applicable during 2004 and even up to 2007.

      As a consequence of the uncertainty created in the Export Maquiladora Industry, the National Council of the Export Maquiladora Industry (Consejo Nacional de la Industria Maquiladora de Exportación or CNIME) filed a request for confirmation of criterion as to the application of the Decree for the years 2004 through 2007 with the Ministry of Finance and Public Credit (Secretaría de Hacienda y Crédito Público or SHCP).

      In response to the request from CNIME and in order to maintain the incentive and competitiveness in the Maquila Sector, on Sept. 29, 2004, the Ministry of Finance and Public Credit issued Official Communication Number 101-1264, whereby the tax authorities inform that the application of Article 11 of the Decree referred to above has an indefinite term, that is, maquila companies may continue to apply it until such Decree is repealed or amended through another Decree published in the Federal Official Gazette; and that, for the time being, the tax authorities do not intend to amend or revoke the benefit contained in the aforementioned Decree.

      The foregoing clearly shows that the SHCP intends to continue to promote the investment in the Maquila Sector and support maquila companies through these incentives, in order to create a stable environment in the tax field.