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Mexican Tax Reform

Mexico’s Fiscal and Legal Reforms 2014. Mexican Tax Reform. John McLees, Manuel Padron, Mounia Benabdallah January 23, 2014 Chicago, Illinois U.S. Mexico Chamber of Commerce. Tax Reform Overview. Proposed on September 9, 2013 Contemplated by the 2013 pact among the major political parties

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Mexican Tax Reform

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  1. Mexico’s Fiscal and Legal Reforms 2014 Mexican Tax Reform John McLees, Manuel Padron, Mounia Benabdallah January 23, 2014 Chicago, Illinois U.S. Mexico Chamber of Commerce

  2. Tax Reform Overview • Proposed on September 9, 2013 • Contemplated by the 2013 pact among the major political parties • Little advance notice of the terms of the reform • Government agreed to significant changes during the legislative process, for example: • On the form of the new tax on dividends • On the terms of some of the new limitations on deductions • On the proposed new Maquiladora tax rules • Effective date – generally January 1, 2014 • Supplemented at the end of 2013 by: • Presidential Decree, Miscellaneous Regulations

  3. Repeal of the “Single Rate Tax” (the “IETU “) • The repeal reduces the tax burden for companies in Mexico and greatly simplifies tax compliance & planning • IETU was calculated on a cash flow basis • On a broader tax base • Including the gross sales price on a sale of assets • With no deduction for related party royalties or most interest payments • IETU was paid to the extent it exceeded the income tax • No IETU implications in 2014 or future years • What about the future? Will Mexico resort to some other minimum tax? • The asset tax applied from 1989 to 2007 • The single rate tax (IETU) applied from 2008 through 2012

  4. Repeal of Cash Deposit Tax (the “IDE”) • IDE only applied to deposits of cash money (bills and coins) • e.g. by retailers and restaurants • IDE functioned as a control tax – directed at the informal economy • Was recoverable by a taxpayer that satisfied its other tax liabilities. • IDE replaced by new reporting obligations for Banks • Regarding companies and individual depositing more than 15,000 pesos (US $ 1,130) per month in cash money

  5. New Excise Taxes (“IEPS”) • One peso per liter tax on sales of sweetened beverages. • Also applies to extracts, powders, and syrups that contain all different types of added sugars (monosaccharaides, disaccharides, and polysaccharides with caloric content) • 8% tax on sales of non-basic food with high caloric content • Tax on sales of fossil fuels • Rates based on CO2 level. • Tax on sales of pesticides • Rates based on toxicity.

  6. New Royalties Taxes on Mining Operations • 0.5% on gross revenue from gold, silver and platinum mining • 7.5% over “extended” profit from any mining activity: • Income minus certain deductions • Including amortization of exploration and development expenses • No deduction for interest or other depreciation • No annual inflation adjustment • Out of that 7.5%: • 80% goes to a fund for the regional sustainable development of mining in States and Municipalities • 62.5% for Municipalities and 37.5% for States • 20% goes to the Federal government

  7. Changes in Tax Rates • VAT • 16% rate extended to the entire country • Repealed the lower 11% rate in the border area • Individual income tax • Increased for those with income of more than 500,000 pesos (approximately US$ 38,500) per year • Up to 35% on income higher than 3 million pesos (approximately US$ 231,000) per year • Corporate income tax • Remains at 30% • Had been scheduled to go down to 29% and then 28% • Tax rate for foreign parties on net income from sale of shares – increased to 35%

  8. New Income Tax Law - Overview • Section numbers changed from prior income tax law • Changes focus on: • Limiting some deductions for companies and individuals • Increasing the tax burden on international operations companies • On corporate distributions • On other payments from related parties in Mexico • On Maquiladora operations • Attempting to place new conditions on benefiting from tax treaties • Eliminating or limiting application of special tax regimes

  9. Individual Income Tax • Gain on the sale of publicly traded shares • Now taxed at 10% • Exemption eliminated • Limitations on total personal deductions • Limited to the lesser of 10% on total income or 4 yearly minimum wages. • All payments must be done through the financial system to be deductible • Practical aspects • Taxpayers from the upper tier claim 87% of the personal deductions. • Individuals who are not obliged to file their annual tax return often do not claim their personal deductions.

  10. Corporate Income Tax – Overview • New income tax law maintains basic structure of the corporate income tax • Tax imposed on net income – generally determined on an accrual basis • Deductions are subject to technical requirements • Deductions of payments to foreign parties • Subject to special scrutiny (especially payments for services) • Thin cap rules limit deduction of interest to related parties • Transfer pricing is a major focus (re amount of income and deductions in related party transactions) • Mexico has generally applied OECD principles • Increasing focus on base erosion and profit shifting

  11. Corporate Income Tax – Overview • No change in the adjustments for inflation and for currency gains & losses • All amounts with significance across years are adjusted for inflation • Imputed inflationary income (loss) is recognized each year for taxpayers with net liabilities (net financial assets) • Currency gains and losses also recognized each year

  12. Corporate Income Tax – Overview • Additional tax continues to be imposed on the distributing company on some corporate distributions • And on some funds transfers from foreign company’s branch/PE to its home office • Applies at 42% to corporate distributions treated as dividends (and branch remittances treated as payments of distributable profits) in excess the CUFIN of the company/branch = 35% on grossed up amount of that excess • CUFIN = cumulative taxable income, reduced by: • income tax paid • nondeductible expenses • prior distributions and • tax losses • Note on timing – current year after-tax income does not increase CUFIN until the end of the year

  13. Corporate Income Tax – Income Recognition • Change in the tax treatment of installment sales • Income recognition now based on accrual • Repealed the option for deferring income recognition to time payments due or payable

  14. Corporate Income Tax – CFC Rules (“REFIPRES”) • New categories of income of a foreign subsidiary on which the Mexican parent is subject to tax on a current basis • Selling / buying real estate. • Granting the temporary use of an asset.

  15. Corporate Income Tax – Deductions • Immediate deduction of investments in fixed assets is eliminated • Must now use normal depreciation schedules in the income tax law • Exception for developers • Still can deduct the cost of land for construction projects in the year of acquisition

  16. Corporate Income Tax – Deductions Food stamps – Requirement for Deductions New requirements for certain deductible expenses Mining industry – Amortization of Expenses Granted via electronic cards approved by tax authorities. Exploration expenses now deductible in a 10 year period. No longer deductible in the year in which they are made.

  17. Corporate Income Tax – New Limits on Deductions Social Security Payments Vehicles For acquisition cost – 130,000 pesos (down from 175,000) For rental payments – 200 pesos daily (down from __) Payments made by the employer on behalf of workers are no longer deductible. Payments of Workers’ Tax Exempt Income Now only 47% deductible (53% deductible if the employer continues to provide the same exempt fringe benefits as in the prior year). Contributions to Pension Funds Now only 47% deductible (53% deductible if the employer does not cut pension contributions from the prior year).

  18. Corporate Income Tax – New Limits on Deductions • Article 28. XXXI – Payments of interest, royalties or technical assistance to a related foreign party (when one party controls the other) • Are now nondeductible (inspired by the BEPS initiatives): • If payment is not considered as existing or not considered as taxable income in the other jurisdiction [e.g. payments from a disregarded Mexican entity to its parent company], or • If the recipient is a transparent entity, unless • (i) its shareholders[its direct shareholders? all of them?] are subject to taxation and • (ii) the payment is an arm’s length amount

  19. Corporate Income Tax – New Limits on Deductions • Article 28. XXIX – Payments to a foreign party that deducts that same payment • Are now nondeductible in Mexico • Unless the foreign party is subject to tax on the related income (if any) currently or in the following year. • This exception provides protection when a US company deducts the expenses of a Mexican subsidiary that is a disregarded entity • Provision designed to avoid “double dipping” (again inspired by the BEPS initiatives) • [when would the limitation apply?]

  20. Corporate Income Tax – New Limits on Deductions • Example of the application of the new rules • Under second rule (XXIX) Payment 4 would be deductible – because US Parent includes the income (and deductions) of Mexican sub in determining its taxable income in the U.S. • BUT – Under the first rule (XXXI), payment 4 appears NOT to be deductible without any exception – because payment is treated “not existing” under the US check the box rules • Result – double taxation

  21. Corporate Income Tax – New Limits on Deductions • Constitutional issues • Are these limitations on deductions Article 28. XXIX and Article 28. XXXI constitutional and thus valid? • They make the deduction depend on the tax treatment of the recipient in the foreign jurisdiction • That should be irrelevant under the under the “proportionality” principal in Mexico: • Providing that a taxpayer must contribute based on its income, profit, return or sign of wealth, consistent with its ability to contribute • These are among the potential constitutional challenges to several provisions in the new law. • First deadline for filing constitutional challenges • February 14, 2014

  22. Corporate Income Tax – Tax Consolidation • Existing tax consolidation regime is eliminated • Must recognize income deferred under consolidation and not already recognized • Additional tax computed in the 2013 tax return • Additional tax paid over 5 years (2014-2018). • New optional consolidation regime starting in 2015 • For those electing by 2/15/14 • Income tax can be deferred for up to 3 years. • Stock ownership requirement: 80%. • Cannot include maquiladoras • Pre-2014 losses cannot be taken into account • No deferral of tax imposed on dividends paid in excess of CUFIN

  23. Corporate Income Tax – Special Tax Regimes • New limitations on simplified tax regime for agricultural activities • Taxpayers with agricultural activities keep some of the benefits of simplified regime • Cash flow instead of accrual for recognizing revenues and deductions • Some tax exemptions • Tax rate reduction to 21% for first 400 million pesos (US $30 million) in taxable income

  24. Corporate Income Tax – Joint Responsibility of Shareholders • As before, joint responsibility only if the Mexican company: • Is not registered, or • Fails to provide notice of a change of domicile, or • Does not having accounting records, or • Hass destroyed its accounting records. • New law has clarified that the extent of joint liability of a shareholder: • Multiply tax liability by its %age participation in the share capital of the company.

  25. Corporate Income Tax – Taxation of Foreign Parties • Overview - overall structure is generally unchanged under the new law • Withholding taxes imposed at varying rates on payment to foreign parties • Higher withholding tax on payments to parties in low-tax jurisdictions without a treaty • PE concept under domestic law applies to impose tax on net income of a foreign party • More aggressive than Mexico’s treaty definitions • For companies holding stocks of goods in Mexico • For companies with independent agents in Mexico • Heavy reliance on tax treaties • To avoid withholding tax on payments for services • To obtain more predictable and less onerous PE rules

  26. Corporate Income Tax – Taxation of Foreign Parties • Changes in taxation of Foreign Pension Fund investments in Mexico • Changes in exemption for gain from the sale real property leased to third in Mexico • Required lease period before sale is now 4 years (up from 1 year). • Tax registration obligation eliminated • As before • Remaining requirements: foreign pension fund must be: • Effective beneficiary of the exempt income and • Exempt from income tax in its country of residency. • Property registered as inventory will not be covered by the exemption.

  27. Corporate Income Tax – Taxation of Foreign Parties • Foreign-party sales (and other transfers) of MexCo shares • Still are generally taxable, even under tax treaties • Tax rate increased to 35% on net gain if the foreign party elects to be subject to tax on net gain on transfer of shares • Default position (absent election) – foreign seller subject to tax at 25% on the gross sale price • Collected as withholding tax if the buyer is Mexican or PE of nonresident company • Mexican company can be liable for the tax • Election to be taxed on net gain (if any) requires seller to take several steps in a timely fashion, including: • Appointment of a representative in Mexico • Note US-Mexico tax treaty provisions for avoiding tax on transfers in an internal restructuring

  28. Corporate Income Tax – New Tax on Dividends • New dividend withholding tax • 10% withholding tax on dividend payments to non-resident shareholders or to individuals • Applies to dividends distributed after 12/31/2013, with exceptions • Increases effective tax rate to 37% on distributed earnings • e.g. (30% x 100) + (10% x 70) = 37% • Withholding tax reduced under tax treaties: • To as low as zero under some treaties: • U.S. treaty (for an 80% shareholder) • Dutch treaty (when the participation exemption applies in the Netherlands) • To a minimum of 8% under the Luxembourg treaty

  29. Corporate Income Tax – New Tax on Dividends • Exemptions from the new dividend withholding tax • Dividends paid from CUFIN accumulated as of December 31, 2013 • Important condition: Must keep records of cumulative undistributed CUFIN as of December 31, 2013 • What about distribution of book retained earnings in excess of CUFIN as of the end of 2013? • Government position – no exemption • Statutory language could support an exemption • What about dividends paid from a Mexican subsidiary to a Mexican holding company in 2014? • Is sub’s 2013 CUFIN included in 2013 CUFIN of the holding company (contrary to the normal rule)? • Yes – under Miscellaneous rule issued in December

  30. Corporate Income Tax – New Tax on Branch Transfers • New tax on branch distributions • 10% tax on distributions (i.e. remittances) from a branch or other permanent establishment to the company’s home office • Applies to transfer of funds from PE to the home office that are treated as a transfer of distributable profits • Also applies on remittances from one PE to another • Exemption for remittances out of the accumulated CUFIN of the PE as of 12/31/13 (similar to exemption for dividends) • Do tax treaties protect taxpayers from this tax? • How do the permanent establishment and business profits articles apply? • What about the nondiscrimination articles?

  31. New Authority to Limit Enjoyment of Treaty Benefits • Authorities can now require a foreign party relying on the treaty to file a document (under oath) establishing the double tax effect in the absence of a treaty • For a withholding tax issue – getting a lower with/holding tax rate under a tax treaty • Practical issue for Mexican party making the payment • Mexican party needs to make sure that certification is on file • To avoid obligation to pay additional tax not withheld • Based on what information if payment is to a third party?

  32. New Authority to Limit Enjoyment of Treaty Benefits • For a PE issue –relying on narrower PE definition in a tax treaty • Practical issue for a Mexican party paying a foreign party • IF the foreign party has a PE, the Mexican party’s deduction will depend on getting a Mexican invoice from the foreign party • Mexican party needs to make sure that the certification is on file • If it wants rely on avoiding a PE under a treaty definition – to avoid need to get Mexican invoice from a foreign company to get a deduction for its payment

  33. New Authority to Limit Enjoyment of Treaty Benefits • Will authorities use the new authority to try to limit benefits granted by Mexico’s tax treaties? • Would that be valid / legal / constitutional in Mexico? • Would the new authority include requiring such a certification in the case of dividend payment? • Note additional grounds for challenging the validity of protection under Mexico-Dutch treaty • Provision in the protocol prohibiting Mexico from taxing dividends subject to a participation exemption in the Netherlands

  34. Corporate Income Tax – New Tax on Dividends • Taking advantage of the Dutch tax treaty to avoid Mexican withholding tax on dividends (case 1) • For a MexCo owned by a Luxembourg company (common ownership structure for maquiladora companies) • Objective: to avoid 8% tax on dividends under the Luxembourg treaty • Option 1 – Move place of effective management of LuxCo to the Netherlands (and meet strict substance rules) • LuxCo treated as Dutch resident and not Lux resident under the Dutch-Lux tax treaty and Dutch law • Option 2 – Cross Border Conversion (of LuxCo into a DutchCo) using EU Directives • Option 3 – Cross Border Merger (LuxCo into a separate DutchCo) using EU Directives (taxable in Mexico, possible exit tax in Lux.)

  35. Corporate Income Tax – New Tax on Dividends • Taking advantage of the Dutch tax treaty to avoid Mexican withholding tax on dividends (case 2) • For a MexCo owned by disregarded US LLC • Objective: to minimize risk of denial of treaty benefits if required to show the avoidance of double taxation. • Question – does new authority to question that apply to dividends (it that an “operacion”)? • Cause Mexico-Netherlands tax treaty to apply by moving place of effective management of the LLC to Netherlands (and meet strict substance rules) • LLC treated as resident of the Netherlands under the Dutch-Mexico tax treaty and Dutch law • Special protection of dividends from Mexico withholding under the Dutch-Mexico treaty

  36. Investing Through the Netherlands • Favorable bilateral tax treaty allows for: • 5% (or even 0%) wh/tax rate on dividends • 5% or 10% wh/tax on interest • 10% wh/tax on royalties • capital gains tax exemption for corporate reorganizations • Bilateral Investment Treaty • Netherlands Participation Exemption regime • Netherlands – favorable outbound structures (e.g. tax treaty with the U.S.) • Importance of Substance US Parent Dutch Resident Company Active Mexican subsidiary

  37. Maquiladora Tax Regime – Overview of Changes • Special lower income tax rate – repealed • 2003 Presidential Decree on maquiladora taxation revoked • Maquiladoras now subject to the regular 30% rate • Remaining income tax benefits for maquiladoras: • Special PE exemption for foreign principals in consignment manufacturing arrangements with maquiladoras • Special exemption from the new limit on deductions for compensation that is tax-free to the employees • New VAT rules for: • Avoiding VAT payments on temporary importation of goods • Will be subject to certification requirements in 2015 • Avoiding VAT on sales of temporarily imported goods to the maquiladora – also will depend on certification

  38. Maquiladora Tax Regime – Special PE Exemption • New requirements for getting a PE exemption for a foreign principal in a consignment manufacturing arrangement • More limited choices on how to qualify for that exemption • Can no longer rely on getting a transfer pricing study demonstrating OECD pricing + 1% of M&E made available on free bailment • Must reach safe harbor threshold for taxable income or obtain an Advance Pricing Agreement (an “APA”) • Taxable income safe harbor unchanged: The greater of 6.5% of the maquiladora’s operating costs or 6.9% of value of all assets in use in Mexico • Standards for issuing an APA are to be developed What about taking into account US-owned assets?

  39. Maquiladora Tax Regime – Special PE Exemption • New requirements for getting a PE exemption for a foreign principal (cont’d) • Impact of new limited choices to qualify – either safe harbor for taxable income or maquiladora APA • Satisfying safe harbor will often require transfer price unacceptable for principals in countries outside US • Mexico’s announced APA standards would pose the same problem • Solutions? • Try to get a bilateral APA to support PE exemption ? • Avoid the need for a special PE exemption • By transferring the M&E to the maquiladora? • By abandoning consignment manufacturing (and going to a buy sell model)?

  40. Maquiladora Tax Regime – Special PE Exemption • New requirements for getting a PE exemption for a foreign principal (cont’d) • Plus new requirements added to the law as conditions for qualifying for that exemption • Expressed as a new definition of maquiladora operation for tax purposes • Re activities that a maquiladora may undertake Income from “productive activity” must come from the maquiladora operation (still being clarified) • Re ownership and prior ownership of machinery and equipment used in Mexico with a new two-yeargrandfather clause for certain maquiladoras with longstanding consignment operations (previously unlimited)

  41. New Conditions for Getting the Maquiladora PE Exemption 41

  42. New Conditions for Getting Maquiladora PE Exemption 42

  43. New M&E Based Conditions for Getting the PE Exemption 43

  44. Maquiladora Tax Regime – PE Exemption for “Shelters” • Third party (i.e. unaffiliated) maquiladoras (commonly called “shelters”) are an important altenative • Consignment operations with a shelter company require a special PE exemption for the foreign company • Not commercially acceptable to rely on safe harbor or maquiladora APA to avoid a PE in a third-party situation • Solution has been an absolute PE exemption for a foreign principal dealing with a shelter (a third party maquiladora) • New limits on that solution under the new income tax law • A foreign company can only benefit from that absolute PE exemption for four years • Measured from later of 1/1/14 or date maquila begins manufacturing operations for the foreign company • After that, what? Establish consignment operations with an affiliated maquiladora? or . . . . . . . .

  45. Maquiladora Tax Regime – Compensation Deductions • Compensation that is tax-free to the employees • New income tax law limits deductions to 53% of payments of such compensation (47% if the amount of such compensation has been reduced from the prior year) • Note – For a maquiladora that elects the safe harbor: • The limit on deductions does not affect its taxable income • It must meet a fixed taxable income threshold • Denial of deductions just reduces the amount it needs to receive for its processing services • Presidential Decree of December 2013 provides: • Special exemption for maquiladoras from new limitation on deductions for compensation that is tax free to the employee • Important for a maquiladora getting and APA

  46. Maquiladora Tax Regime – Value Added Tax • Starting 1/1/15, VAT is payable on temporary imports of materials, components, machinery and equipment • Will also apply to auto manufacturers’ imports into their fiscal deposit regimes • New credit mechanism established to avoid cash payment of VAT, only for companies satisfying new certification requirements • Certification requirements published on January 2 • Other trade benefits also available from certification • Starting 1/1/15,VAT will also be payable on foreign party sales of temporarily imported goods to a maquiladora • Immediate credit for a maquila that gets the certification • Law amended to eliminate supplier obligation to withhold VAT on sales to a maquiladora

  47. Certification Rules – VAT and IEPS Certification to avoid payment of VAT and IEPS in temporary importations Three categories: Application filed online with the company’s advanced electronic signature

  48. Certification Rules – VAT and IEPS • 40 days to issue certification • Cannot request certification within: • 6 months when not complying with infrastructure requirements during the certification procedure • 2 years when granted certification is cancelled

  49. Certification Rules – VAT and IEPS Benefits • Same as Category A, plus: • VAT refund in 10 days • Certification valid for 3 years • No audit in 60 days for self-assessment • Simplified ICS • (to be defined by Hacienda in Rules) • Invitation letter prior an audit • No immediate suspension of Importer’s Registry when falling into suspension cause • Monthly consolidated pedimentos • No declaration of serial numbers in temporary import pedimentos (but in ICS) • Exports clearance at company’s domicile Category AAA • Same as Category A, plus: • VAT refund in 15 days • Certification valid for 2 years • No audit in 30 days for self-assessment • Invitation letter prior an audit Category AA • Mechanism of tax credit for VAT/IEPS to be paid upon temporary importations • VAT refund in 20 days • Certification valid for 1 year Category A

  50. Certification Rules – VAT and IEPS • Requirements category A: • Inventory control system • Obtain a favorable opinion on tax compliance from Hacienda • Not be in the list of non-compliant companies, published by Hacienda • Have valid digital seals issued by Hacienda • All employees must be registered in Social Security • Evidence that the value of finished goods returned equal at least 60% (80% for sensible goods) of value of temporarily imported materials • Strict compliance with other tax, customs, IMMEX and labor obligations

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