Tax Policy & Controversy Briefing | October 2013
Mexico's ambitious tax reform program
Increased burden and heightened enforcement draws criticism
The Mexican Government faces a serious challenge: within just a few months of the inauguration of President Peña, it has become clear that the financial requirements of his social programs – in themselves a significant element of his election manifesto - are not matched by the tax revenue currently being collected, which as a percentage of GDP is not only among the lowest in the OECD but is below even the average in Latin America, and barely half of Brazil’s.
Last year, the Federal Congress approved an amnesty program (“Ponte al Corriente”) through which taxpayers not current with their federal tax obligations could come forward and secure compliance while enjoying substantial discounts in the process. The amnesty program, which was managed by the Mexican revenue service (SAT) was able to secure funds to the order of $40 billion Mexican Pesos (around US$3 billion). However, much more revenue will be needed to pay for the promised social programs, and because of the amnesty, less revenue may be available from current and future enforcement efforts.
Of the forgiven amounts (the majority of which were already being litigated in federal courts), it could typically be expected that the SAT would have recovered at least 50% during the next three to four years, based upon the recent experience in the percentage of cases won by the SAT against taxpayers. In other words, the Government started with some extra cash this year, but is still in need of much more for the coming years.
It now appears, however, that Mexico may seek revenue from targeting what is perceived as inappropriate tax planning. Mexico is a very active OECD member, and, starting with the OECD Secretary General, José Angel Gurría (who is a former Mexican Minister of Finance), includes many active members in the Working Parties of the Tax Committee: Armando Lara, a high ranking officer of the Mexican Ministry of Finance and Public Credit (SHCP), as well as being the President of the Tax Experts Committee of the United Nations, currently chairs the OECD’s tax Working Party 10 (WP10), a group that works within the OECD on strategies to “tackle aggressive tax planning,” following a report with the same name issued by the OECD a couple of years ago.
Additionally, it is worth considering that Mexico is a member of the G20, and it was in their meeting in Mexico that the G20 asked the OECD to work on base erosion and profit shifting. At the recent Moscow meeting of the G20, the Secretary General of the OECD presented the Heads of State of the G20 countries (Mexico among them) the final Report Addressing Base Erosion and Profit Shifting (the BEPS Report) and the subsequent Action Plan on Base Erosion and Profit Shifting (the Action Plan), also prepared by the OECD.
Mexican Tax Authority increases focus on auditing supply chain structures
Recent developments within the Mexican Tax Administration Services (SAT, for its acronym in Spanish) demonstrate an increased focus on auditing supply chain restructurings. This increased focus appears to be a consequence of personnel changes within Mexico's Treasury Department, including the SAT. Specifically, the newly appointed SAT's General Administrator for Large Taxpayers has expressed in several forums his intent to identify and challenge companies that have undertaken restructurings to reduce their tax liabilities in Mexico while maintaining their business functions and customers in Mexico, including maquila conversions. This audit program initiative is intended to challenge companies that have been engaged in what the SAT considers "aggressive tax planning," whereby profit shifting has been identified.
Read more in this EY Global Tax Alert.
The BEPS Report deals with cases of international tax planning of multinational enterprises (ME) through which, the OECD says, the tax bases of the countries around the world are being eroded and the profits that should be taxed in the country in which those profits are generated are shifted to countries with more favorable tax regimes. The BEPS Report and the Action Plan also suggest a series of measures that may be adopted multilaterally, after proper consideration and analysis over the next few of years.
Mexico thus is faced with the challenge of introducing a tax reform proposal that will allow the Government to generate the tax revenue required to operate the country, fund the new social programs, and take the country to a new level of development. In this context, all of the OECD suggested actions against aggressive tax planning were likely “music to the ears” of the Mexican tax authorities, already predisposed as they are to follow OECD suggestions.
In this context, the revenue authorities abandoned the idea of proposing a lowering of the corporate income tax rate and the elimination of some “preferential tax regimes” for labor unions, political parties and other “socially relevant entities”, together with a substantial increase of the value added tax (VAT) and the elimination of exempted goods and services under VAT Law.
Instead, the team in charge of tax reform prepared a package, which was formally submitted to the Federal Congress by President Nieto on September 8, which is much more in line with the current thinking of the leftist opposition party (PRD) while also agreed to by the other main opposition party (PAN), in an effort to try to secure the collaboration in Congress to secure the approval not only of the tax reform, but also of oil and energy reform to transform PEMEX and its tax regime.
The resulting proposal is tough on various Mexican industries and on MNCs, and in addition, increases the tax burden on the middle class by eliminating the VAT exemption on the sales of homes, on private school fees and on mortgage interest for first homes, and as well as increasing the income tax rate to 32% while severely restricting the deductibility of medical expenses and other personal deductions.
Among the most relevant changes that affect MNCs and local Mexican industries and business in general are:
- The elimination of the VAT exemption on temporary imports, even if under a valid Maquila Program;
- The limitation of the deductibility, for income tax purposes, of payments made to employees which are not taxable in their hands;
- The elimination of the deductibility of the reserves of insurance companies, even with respect to those reserves required as a matter of law;
- The reduction of the deductible amounts for certain assets deemed not necessary for the operation of businesses;
- The inclusion of a tax on dividends at a 10% rate, on top of the corporate rate of 30% which results in an effective rate on corporate profits of around 37%, without considering the deduction limitations which can elevate the actual effective rate much higher. This tax is proposed in such a way that it would not be reduced by tax treaties.
- The abandonment of scheduled reductions in the corporate income tax rate in 2014 and 2015, leaving the current 30% rate in place.
Worthy of particular comment are the following proposals, which may be classified as “BEPS inspired”:
- The inclusion of a provision in the Income Tax Law allowing the Mexican tax authorities to condition the application of existing tax treaties in cases where the resident of the other country is a related party of the Mexican resident making the payment, and to request evidence of the double taxation that would otherwise occur if the treaty is not applied as a requisite for its application.
If approved, this provision would empower the SAT to actually override treaties, which is not only against International Law, but against the firm criteria of the Mexican Supreme Court, which clearly establishes that domestic law is inferior in hierarchy than international treaties.
- Payments made by resident companies to related parties resident in other countries in which the income tax on the income received is less than 75% of what would have been the Mexican tax on the same income will not be deductible for income tax purposes.
If this provision is approved as proposed, it would severely affect MNCs, particularly those groups with operating companies in countries where the corporate income tax rate is less than 22.5% (which would impact countries such as diverse as the Czech Republic, Denmark, Singapore, Sweden, Switzerland and the United Kingdom, for example).
- Payments, expenses, investments and all type of deductions in general which are taken in Mexico but also deducted in other countries, will not be deductible for income tax purposes for Mexican resident entities. If this provision is approved as proposed, all of the entities established in Mexico by US parent companies in which the check the box election has been made (to treat the Mexican entity as transparent) would lose all of their deductions and subsequently would be taxed on their gross income.
- The inclusion of a new General Anti-avoidance Rule (GAAR) in the Federal Tax Code allowing the tax authorities to re-characterize transactions and structures with no demonstrable business purpose (as defined: in which non quantifiable economic benefit exists). This provision as currently drafted would, if approved, generate many conflicts that will most probably end up in court, taking away legal certainty on the structural part of businesses in Mexico.
- The inclusion of a modified provision concerning the piercing of the corporate veil for tax purposes, through which shareholders will become jointly liable for taxes due from companies. If approved as proposed, the new rule will make the shareholders liable in all cases, as a general rule, and not only in the case of fraud or abuse. This provision is clearly against all known and defined corporate law principles in Mexico and could severely limit new investments in the country.
- A whole new series of rules regarding tax related crimes through which officers in corporations and even legal and tax advisors may be found liable and subject to imprisonment.
The new reform package has attracted criticism at both national and international levels. We are confident that Mexican Congress will carefully review the proposals and are optimistic the proposed changes will not be approved precisely as they are drafted today. EY continues to work closely with members of Congress to improve the proposal and urge others to make their views known.
Read EY’s full coverage of the reform package:
- Manuel E. Tron
Americas Tax Policy Leader