On 10 October 2014, Mexico’s federal tax authority, the Servicio de Administracion Tributaria (SAT), published a package of miscellaneous tax rules (the “October 10 Rules”) that included guidance on various Mexican tax provisions.
One of the most important benefits of the October 10 Rules is the ability to deduct, for income tax purposes, certain expenses that are apportioned from foreign taxpayers (e.g. home office or management expenses), provided certain requirements are met. Companies that conduct operations in Mexico, through a Mexican subsidiary or other entity, and that charge expenses to said subsidiary, need to understand these rules.
Mexico’s income tax laws establish that Mexican taxpayers cannot deduct expenses which have been determined based on an apportionment of expenses from non-Mexican taxpayers, regardless of whether those expenses are incurred in Mexico or abroad. Under an exception to this rule, a foreign enterprise with a permanent establishment in Mexico is allowed to apportion certain expenses incurred outside Mexico in order to calculate the permanent establishment’s Mexican tax liability. This prohibition was designed to prevent Mexican taxpayers from overstating or understating net taxable income by apportioning expenses incurred offshore that the SAT cannot readily audit. Prior to the issuance of the October 10 Rules, Mexican taxpayers could only deduct expenses that are directly and identifiably incurred, provided all documentation and other requirements are met.
On 19 March 2014, Mexico’s Supreme Court ruled that the general prohibition on apportioning deductions is unconstitutional. After this ruling, the SAT published the October 10 Rules.
Until the October 10 Rules became public, Mexico provided very little guidance regarding the amount that a foreign parent or related company could charge to a Mexican taxpayer for expenses related to management or technical assistance activities that benefit the Mexican taxpayer. Based almost entirely on custom and administrative practice, the method that the SAT most commonly accepted was the “time and materials” arrangement, where the foreign parent or foreign related party bases an intercompany charge on a reasonable hourly rate for charges. This made the determination of expenses incurred for management services, or technical assistance, a very cumbersome process and offered little certainty for the taxpayer in the event of a challenge by the SAT. Due to the lack of guidance, Mexican taxpayers commonly encountered challenges in preparing a defensible position for legitimate expense apportionments.
The October 10 Rules also contribute to making the Mexican taxation system more uniform with those of other OECD countries, where the deduction of apportioned amounts is allowed.
The general prohibition on the apportionment of expenses incurred by non-Mexican related parties resulted in significant adverse tax consequences. For example, the prohibition could result in an increase in the Mexican taxpayer’s net taxable income, or in a reduction of net operating losses. In addition, the disallowance of apportioned expenses could result in the imposition of a 16 percent value added tax (VAT) on some, or all, of the amounts disallowed. Contrary to most situations where VAT arises, the VAT resulting from the disallowance of these apportioned expenses cannot be recouped.
Requirements for deduction of apportionable expenses
The October 10 Rules establish the following requirements that have to be met in order for a Mexican taxpayer to deduct expenses determined based on an apportionment with non-Mexican taxpayers:
The expense must be directly related to the Mexican taxpayer’s activities; for example, assume a company has two international lines of business: manufacturing of garments and manufacturing of shoes. The company has a Mexican subsidiary that manufactures and sells garments in the Mexican market but does not sell shoes at all. Thus, the travel expenses and costs incurred by the company’s engineering department that oversees the company’s global garment manufacturing operations are “apportionable” to the Mexican subsidiary, but the marketing expenses related to the global shoe division are not.
Any entity whose expenses are apportioned must qualify as a resident for tax purposes of a country with which Mexico has an Agreement for the Exchange of Tax Information. The US-Mexico Treaty to Avoid Double Taxation satisfies this test. Mexico has an exchange of information agreement with Canada, as well as with most EU and Asia-Pacific Economic Cooperation (APEC) countries, that satisfies this requirement.
The services and activities for which the expenses are incurred must actually be performed. For this purpose, the Mexican taxpayer must maintain documentation that will substantiate the expenses (e.g. airline tickets and travel expense receipts).
The Mexican taxpayer must maintain work papers in support of the amounts apportioned.
The related foreign entity that charges the apportioned expenses must issue invoices in the name of the Mexican taxpayer that meet special invoicing requirements under Mexican tax law.
The expenses apportioned should be commensurate with the benefit the Mexican taxpayer obtains or expects to obtain.
The expenses must only be apportioned among entities that benefit or will benefit from the activities and services.
The Mexican taxpayer and the related foreign entity must sign a written contract. The contract must include, among others, the following items:
name, address and country of residence of the involved parties
functions performed by each involved party
methodology used to apportion the expenses
signatures of competent officers of each of the involved parties
Expenses apportioned with foreign related parties
The following additional requirements must be satisfied in the case of services or activities performed by foreign related parties:
The services or activities must be those that unrelated parties would be willing to pay for, or would be willing to perform themselves.
The services or activities must not constitute “shareholder activities”, as defined by the OECD Transfer Pricing Guidelines (i.e. those activities that a parent company performs with the sole purpose of maintaining its investment in other companies, as opposed to actual services or activities that result in an actual benefit). Examples of shareholder activities that cannot be apportioned to Mexican taxpayers are: (1) costs of activities relating to the juridical structure of the parent company itself, such as meetings of shareholders of the parent, issuing of shares in the parent company, and activities of the supervisory board; (2) costs relating to reporting requirements of the parent company, including the consolidation of reports; and (3) costs of raising funds for the acquisition of its shares.
The services or activities in question cannot also be provided by another related or unrelated party that charges for such services and activities.
The intercompany charges must satisfy the arm’s-length standard, and the Mexican taxpayer must maintain supporting documentation — in most cases, a transfer pricing study is the only type of documentation that the SAT will accept.
The expenses must not also be included in other charges, such as royalties, technical assistance, or commission or agency contracts.
Consequences of non-compliance
Failure by a Mexican taxpayer to meet any of the above requirements may result in a disallowance of the apportioned expense on audit. As stated above, the disallowance of the deduction of said expenses would not only increase the Mexican taxpayer’s Mexican income tax liability, but also result in the imposition of a 16 percent VAT on the amounts disallowed. The Mexican taxpayer would have no ability to recover this tax.
What should you do?
The October 10 Rules offer the opportunity for non-Mexican companies that have Mexican subsidiaries to examine the form in which they are charging their Mexican subsidiaries for management or technical assistance services and activities and make any adjustments necessary to ensure that the deductions will be allowed. A review of the Mexican taxpayer’s policies regarding apportionment of intercompany charges could allow the taxpayer to establish a more robust (and beneficial) policy regarding intercompany charges.
Disclaimer: The information contained herein is general in nature and based on authorities that are subject to change. McGladrey LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. McGladrey LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations.
Circular 230 Disclosure: This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.