Mexican Tax Reform: Intercompany Debt & Transfer Pricing Issues
On November 12, 2021, the Mexican Official Gazette published a decree enacting various provisions of the Mexican Tax Reform 2022 (Tax Reform). Among other things, the provisions adjusted thin capitalization rules under Article 28 (XXVIII) of the Mexican Income Tax Law (MITL). Visit this site for a copy of the guidance.
Beginning January 1, 2022, the adjusted thin capitalization rules became effective. As discussed below, the adjustments potentially affect taxpayers conducting business in Mexico with financing provided by non-Mexican related parties. This article identifies some Mexican income tax, transfer pricing, and U.S. income tax issues for taxpayers to consider regarding the efficiency of their income tax positions.
Mexican Tax Considerations
For context, Mexico’s thin capitalization rules aim to cap excessive deductions for interest produced by a ratio imbalance between limited capital and large debt. Mexican affiliates of multinational corporations frequently claim these excessive deductions since lower tax rates apply to interest payments rather than dividend payments. To address this common problem, interest payments arising from debts with non-Mexican related parties that exceed three times the affiliate’s own equity are not deductible for Mexican income tax purposes.
To determine the amount of debt that exceeds the deductible limit: subtract (i) the amount resulting from multiplying the Mexican taxpayer’s equity by three from (ii) the average annual sum of all the taxpayer’s interest-bearing debts.
Before Tax Reform, a taxpayer’s equity for thin capitalization was determined under one of two methods: (i) the books balance method or (ii) the tax attributes method. Under the standard books balances method, a taxpayer’s equity was measured by adding up the initial and final annual book balances and then dividing the result by two. Under the optional tax attributes method, a taxpayer’s equity was instead measured by accruing the opening and closing balances of the contributed capital (CUCA), net tax profit (CUFIN), and net reinvested tax profit (CUFINRE) tax accounts and then dividing that result by two.
|Equity Determination for Thin Cap (Pre-Tax Reform)|
|Method||STANDARD: Books Balances||OPTION: Tax Attributes|
Common stock: $50,000
Retained profits: $25,000
|In this scenario, the tax attributes method allows for a larger sum of deductible interest payment to foreign related parties.|
Effective fiscal year 2022, Tax Reform adjusts how the tax attributes method calculates equity. This method now requires decreasing the sum by the yearly average of the taxpayer’s net operating tax losses (NOLS) that remain outstanding before the closing of the fiscal year.
|Equity Determination for Thin Cap (Post-Tax Reform)|
|Method||STANDARD: Books Balances||OPTION: Tax Attributes|
Common Stocks: $50,000
Retained Profits: $25,000
|In this scenario, the books balances method allows for a larger sum of deductible interest payments to foreign related parties.|
Further, Tax Reform now limits when a taxpayer may select the tax attributes method at all. Under a new rule, if the variation between calculating equity under the books balances method and the tax attributes method exceeds 20 percent, then a taxpayer is ineligible to select the tax attributes method. A narrow exception exists for taxpayers that prove to the Mexican tax authorities—upon an official audit—that the situation that caused the greater than 20 percent variation stemmed from a business reason.
|Option Eligibility Evaluation (20% Gap)|
|STANDARD: Books Balances||$35,000||$35,000||$35,000|
|OPTION: Tax Attributes||$30,000||$38,000||$15,000|
|Tax Attributes Method Available||Yes||Yes||No|
NOTE: Figures not related to charts above
Doubts and confusion arise from the ambiguity within these Tax Reform rule adjustments. After Tax Reform, taxpayers now experience additional complications when using the tax attributes method and fully complying with the method’s new eligibility criteria. By adding these complications, Tax Reform (i) eliminates an option for taxpayers whose operations are not configured to obtain a tax benefit from the payment of interest abroad, as well as (ii) reduces the opportunity to select the tax attributes method should this scenario be more favorable for taxpayers, as originally intended by lawmakers.
For instance, insufficient clarity exists with respect to the 20 percent variation eligibility rule enacted under Tax Reform. By common sense, the percentage should be considered as a gross up between both methods to determine the taxpayer’s equity, but the legal wording is not clear enough. Likewise, it seems unrealistic for taxpayers to provide a business reason in the application of an optional benefit under MITL, since the method is selected merely for a tax benefit and not a business one.
To reduce the risk of triggering a thin capitalization issue under Mexico’s new rules, potentially affected taxpayers should (i) determine nondeductible interest payments derived from their financing with related parties abroad, (ii) evaluate—on a case-by-case basis—the equity calculation methods available, and (iii) consider whether restructuring their debt versus equity ratio is necessary.
Transfer Pricing Considerations
The recent modifications to MITL Article 28 (XXVIII) also highlight the importance of supporting intercompany financing arrangements for Mexican taxpayers. The deduction of payments of interest to foreign related parties often depends on the characterization of a loan as a necessary loan that has a “business reason.” Taxpayers should make reasonable efforts to establish that their intercompany financing arrangements meet the necessity requirement and that the funds are invested in the borrower’s business. Crucially, this helps avoid the risk of a payment recharacterization from interest to a dividend.
From a practitioner’s perspective, reasonable efforts must include two key elements for taxpayers:
- Putting in place intercompany agreements, and
- Proving—with appropriate transfer pricing documentation—that the interest charged is not above the arm’s-length standard rate.
This is expected both for traditional financing agreements as well as for other types of indebtedness, such as excessive intercompany balances arising from long-standing accounts payable to foreign related parties. Please note that—from the tax authorities’ perspective—taxpayers also should comply with other formal requirements, such as proof of payments, workpapers, invoices, records in the books of account of the borrower and the lender, and support that the loan is indeed indebtedness (as opposed to a capital contribution), including documentation of the borrower’s economic and legal ability to comply with its obligations, among others.
The determination of an arm’s-length price is an exercise often overlooked by taxpayers. This is because the exercise requires a detailed analysis of the credit risk profile of the borrower and available data on market comparables for similar profiles of risk, term, currency, and interest rate type around the date of the taxpayer’s loan origination. Failure to support the appropriateness of interest payments made by a Mexican taxpayer to its foreign related parties could lead to tax inefficiencies, as a portion of the interest paid would be nondeductible for the Mexican taxpayer yet likely includible in the tax base as interest income of the related party holding the obligation.
Foreign investors with loans to related parties in Mexico should closely monitor the performance of their operations in Mexico and make projections on their debt-to-equity ratios under the cap options described above to elect their best option, as the methodology elected for FY 2022 is expected to be applied for a minimum term of five years. Of course, this exercise depends on the determination of a market rate of interest, an exercise that taxpayers should not overlook.
U.S. Tax Considerations
As hinted above, if a U.S. entity’s loan to its Mexican related party is “bona fide,” then the related party may generally deduct interest payment amounts for U.S. income tax purposes. A U.S. entity’s loan is typically “bona fide” when—among other things—the Mexican related party’s debt-to-equity ratio is 3 to 1 (3:1) or less. As explained above, however, Tax Reform changes the way a Mexican related party’s equity is calculated. Under Tax Reform, a Mexican related party’s net equity now accounts for—and is reduced by—NOLS, including foreign currency exchanges and other related losses. Since net equity reductions may increase a Mexican subsidiary’s debt-to-equity ratio, thereby undercutting whether loans are “bona fide,” Tax Reform may limit a Mexican subsidiary’s ability to deduct interest payments on intercompany loans for U.S. income tax purposes.
To preempt this concern, Mexican related parties may need to be recapitalized or intercompany loans denominated in U.S. dollars may need to be redenominated in Mexican pesos. If the intercompany loan’s terms change such that the exchange risk shifts, then a “significant debt modification” of the loan may occur for U.S. income tax purposes. If a “significant debt modification” of the loan occurs, then U.S. tax law generally treats the modification as a deemed exchange whereby the new (modified) loan is issued for “property” (the old unmodified loan). Depending on the facts and circumstances, the debt holder would generally realize gain or loss on the deemed disposition of the old (unmodified) loan. The holder’s gain or loss should be the difference between the issue price of the new (modified) loan and the holder’s adjusted tax basis in the old loan.
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