On October 30, 2019, Mexico’s Congress approved a sweeping 2020 tax reform package intended to combat base erosion and profit-shifting arrangements. The tax reform revisions relate to the following laws and regulations:
- Mexican Income Tax Laws (MITL)
- Value Added Tax (VAT)
- Excise Tax Laws (IEPS)
- Federal Tax Code
These changes impact businesses with cross-border transactions, Maquiladora arrangements, Mexican independent agents, and sellers of digital goods and services to Mexican buyers. Most of the provisions entered into effect on January 1, 2020, with some rolling effective dates through 2021.
Generally, the Mexican tax reform (MTR) neither creates new taxes nor rates. Instead, it implements the recommendations of the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Action Plans 1, 2, 3, 4, 7, and 12.
Here’s a summary of each plan:
- Action 1. Addresses the tax challenges created by the digital economy.
- Action 2. Aims to neutralize the effects of hybrid mechanisms.
- Action 3. Introduces the Controlled Foreign Company regime.
- Action 4. Limits the erosion of the taxable basis through interest and other financial payment deductions.
- Action 7. Updates permanent establishment (PE) rules.
- Action 12. Requires disclosure of tax shelters.
The BEPS initiative seeks to align taxable profits with jurisdictions where a company is actually generating revenue by taking a markets-based approach to income sourcing. Many countries around the world have adopted new policies in response to the OECD’s BEPS initiative, which has been a driving force in new tax reform policies around the world.
Following are four major changes introduced by MTR.
Mexico has restricted deduction of payments made by Mexican subsidiaries if the foreign recipient isn’t sufficiently taxed on that income. Sufficient taxation is 22.5% for entities and 26.5% for individuals. The rule applies where the payment is directly made to a foreign related party, or indirectly made through third parties under a structured arrangement—similar to step-transaction doctrine.
The restriction applies to any kind of payment, such as an acquisition of inventory, expanding beyond passive payments such as dividends, interest, and royalties.
Certain exceptions may apply—such as income derived from trade or business—with sufficient substance through assets and personnel. This must be carefully reviewed on a case-by-case basis.
For instance, the tax threshold is limited to effective taxation abroad, but leaves aside tax credits and incentives. Additionally, if all income and deductions are recognized at the same moment, a statutory tax election exists that may be difficult to comply with.
General Anti-Avoidance Rule
Mexico has enacted a General Anti-Avoidance Rule (GAAR), which has significantly broadened anti-avoidance rules, allowing the Mexican tax authorities (SAT) to disregard transactions for tax purposes if there’s a lack of business purpose for a transaction that’s also providing a tax benefit.
Additionally, a transaction won’t be considered to have a business purpose if the economic value is less than the tax benefit of the transaction. A tax benefit includes any elimination, reduction, or temporary tax deferral, even if the tax benefit is created through deductions, credits, or other incentives.
Reporting Obligations for Foreign Entities
Effective January 1, 2021, all tax transparent foreign entities or arrangements in Mexico—such as LLCs—will be treated as taxpayers subject to Mexican tax. This could potentially lead to increases in withholding taxes with regard to Mexican entities on the distribution of:
- Capital gains
Some protection is provided by the US–Mexico income tax treaty, which specifically addresses pass-through entities. Currently, only 19 out of Mexico’s 61 income tax treaties address pass-through entities. These are treaties with Australia, Austria, Barbados, Brazil, Czech Republic, Denmark, Germany, Iceland, Indonesia, Israel, Kuwait, Malta, Poland, Russia, Singapore, South Africa, Sweden, and Uruguay.
Careful review of how these new rules apply to specific pass-through structures is highly recommended. For instance, there isn’t currently guidance regarding how an S corporation will be viewed under the new rules. However, the US–Mexico income tax treaty should prevail in restricting Mexican domestic rule.
Permanent Establishment Definition
The definition of what determines a permanent establishment (PE) in Mexico has been expanded.
For instance, the scope of an independent agent—even if there’s no fixed place of business—now establishes a PE if the agent habitually concludes contracts or habitually plays the principal role when leading to the conclusion of contracts—either in the name of, or on behalf of, its principal—that:
- Determine a conclusion of contracts related to the sale of property
- Reveal the use or satisfaction of an asset owned by or for a nonresident
- Obligate a nonresident to provide a service
Additionally, the new regulations clarify that an individual or legal entity won’t be seen as an independent agent if the agent exclusively performs—or almost-exclusively performs—on behalf of a nonresident-related party.
While the US–Mexico treaty provides protection, businesses should review all agency relationships to determine if they fall under the new expanded definition.
Interest Expense Limitations
The deduction for interest expense limitation is now capped at 30% of the net adjusted taxable income. Any interest amount exceeding the 30% limit may be carried forward, but it must be deducted within 10 years.
These limitations won’t apply to:
- Interest derived from debts of financial institutions
- Construction of real estate located in Mexico
- Public infrastructure
- Generation, transmission, and storage of electricity and water
- Exploration, extraction, and transportation storage of hydrocarbons
A de minimis exception exists for the first 20 million pesos—approximately $1 million, based on the current exchange rate—of net deductible interest. Mexican related parties must share the limitation on a proportional basis.
Value Added Tax and the Digital Economy
The Value Added Tax (VAT) definition has also been expanded to encompass digital services performed in Mexico through a digital platform, which are subject to a 16% VAT rate. Additionally, foreign digital providers will be required to register in Mexico as a VAT withholding agent and comply with Mexican digital invoicing laws.
The new VAT rules are applicable to Mexican entities and nonresidents with or without a Mexican PE and are effective June 1, 2020. There isn’t a small-seller exception. A single digital download to a Mexican customer, regardless of the amount of the transaction, is within scope.
We’re Here to Help
MTR is a sweeping package that impacts businesses with cross-border transactions, Maquiladora arrangements, Mexican independent agents, and sellers of digital goods and services to Mexican buyers. Through our Praxity Alliance, we’re ready to help you learn how these changes may affect you. To get started, contact your Moss Adams professional.
Special thanks to Hugo Ortega for his contributions to this article.