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by Mauricio Hurtado, Esq.
and Fred Barrett, Esq.
Mexico City, Mexico
Mexico is continuing to advance legislation requiring cross-border related-party taxpayers to demonstrate that their transfer pricing transactions have adequate substance in Mexico. The purpose of this article is to provide a pragmatic evaluation of “substance over form” in light of recent transfer pricing controversies with the tax authorities.
Mexican legislators have attempted to address substance-over-form issues for many years. Nevertheless, the laws and legal system, including the common use of constitutional arguments, have allowed many taxpayers to rely on formalistic requirements to prevail for tax purposes. Mexico began to launch an extensive income tax treaty network in 1992, and became a member of the Organisation for Economic Co-operation and Development (OECD). These events, among others, resulted in the enactment of the arm's-length principle in 1997. The legislation essentially required an analysis and possible adjustment of income tax results based on how a transaction would have been structured between unrelated parties in “comparable” circumstances.
It is important to clarify that the arm's-length standard requires an adjustment irrespective of any contractual obligation undertaken by the parties to pay a particular price or of any intention of the parties to minimize tax. Thus, a tax adjustment under the arm's-length principle would not affect the underlying contractual obligations for non-tax purposes between the related parties, and may be appropriate even where there was no intent to minimize or avoid tax. 1 Accordingly, the form of a transaction is not changed as a result of a transfer pricing adjustment.
1 Paragraph 1.2 of the OECD transfer pricing guidelines.
Notwithstanding the above, transfer pricing is not a science, but rather is based on economic and business circumstances, requiring judgment and common sense. 2
2 Paragraph 1.12 of the OECD transfer pricing guidelines.
Statutory Framework in Mexico
Laws are formalistic in Mexico. For example, Article 5 of the Federal Tax Code (FTC) establishes that tax provisions relating to the subject, object, base, tax rate, or tax tables are to be strictly applied, while other provisions can be interpreted. Essentially, in most cases, the above provision is applied strictly as to the facts as legally structured, although some room appears to be left for interpreting the intention of laws.
The authors of this article consider that transfer pricing at least refers to the base and therefore should be strictly applied according to the above criteria. Controversy can and does, arise especially because, as mentioned, transfer pricing is largely a matter of judgment and very different results may be acceptable, depending on all of the facts and circumstances in any given cases.
Article 215 of the Mexican income tax law (MITL) defines the arm's-length principle, essentially using the same terminology as the OECD transfer pricing guidelines, as follows:
Taxpayers executing transactions with related parties must determine their taxable revenues and their authorized deductions by considering the prices and amounts they would have used as consideration, if comparable transactions had been executed between independent parties…. Operations or entities are comparable when there are no differences between them having a significant effect on the price or amount of the consideration or the margin of profitability as determined using the transfer pricing methods in Article 216 of the MITL, and when such differences do exist, these are eliminated by making reasonable adjustments. [Emphases added.]
The terms “significant” and “reasonable” are not defined and therefore this is an area of potential controversy. Notwithstanding this uncertainty, the rules require an evaluation of the essence of the related-party transactions.
In addition, the last paragraph of Article 215 of the MITL provides that the OECD transfer pricing guidelines shall be used to interpret the transfer pricing provisions to the extent congruent with Mexican income tax legislation and any applicable Mexican income tax treaty.
Notwithstanding the application of these guidelines, there are still several shortcomings in the Mexican transfer pricing legislation. For example, there are no detailed regulations on transfer pricing, and pro rata allocations from abroad are nondeductible even though the OECD allows reasonable allocations in most circumstances.
It is worth noting that the OECD transfer pricing guidelines are merely guidelines, and administering them is, again, an exercise involving a large degree of judgment — in apparent contradiction with Mexico's requirement to apply a strict application of the law. This will undoubtedly lead to a number of disputes in which the outcome may be difficult to predict.
Some of these controversies could be resolved by further legislative clarification, although it is important for such legislation to be congruent with international transfer pricing criteria to prevent inequitable positions by tax authorities.
In any event, the arm's-length principle goes to the core consideration of economic substance, and its enactment represented a major shift in Mexico.
Nevertheless, there is significant tax legislation currently regulating the substance of certain transactions. Below are a few examples attempting to regulate substance over form:
1. Thin capitalization rules, disallowing excess interest for entities when their debt-to-equity ratio exceeds 3:1, were enacted in 2005. 3
2. Back-to-back loan rules, reclassifying interest as dividends, have been in effect for several years. 4
3. Purchases of Mexican shares by nonresidents at a bargain purchase price (by more than 10%) results in a taxable gain. 5
4. Reductions of capital within two years of a capital contribution cause the contribution to be recharacterized as a sale. 6
3 3 Article 32, Fraction XXVI, of the MITL.
4 Article 92 of the MITL.
5 Article 190 of the MITL.
6 Article 89 of the MITL.
Transactions Under Increased Scrutiny
Several taxpayers have undergone cross-border restructurings for business purposes on a global basis, and in many cases these transactions have been implemented in Mexico as part of a global process. These transactions include conversions to strip-by-sell or commissionaire arrangements, usufruct transactions, debt alignment, and migration of intangibles and others. The approach often used by the Mexican tax authorities involves several different arguments, including questions on transfer pricing, the existence of a permanent establishment, Value Added Tax (VAT) effects of cross-border transactions, and insinuations of the possible application of simulation provisions under the new legislation effective in 2008 for transactions occurring as of that year or earlier and affecting tax results after 2007.
The authors believe that restructurings are appropriate when it is established that they have economic and business substance. However, in certain cases the tax authorities have maintained that transactions did not have economic substance, thereby potentially weakening the taxpayers' arguments. In some cases, taxpayers have been forced to consider the 2007 amnesty provisions (which expired on December 31, 2007), despite having solid technical arguments and business purposes and the ability to demonstrate real changes in assets, functions, and risks.
Because the costs of guaranteeing the tax assessments are so high, pragmatic business decisions are required in arriving at effective settlements, and taxpayers can be unduly pressured to consider their options on the basis of the cost rather than technical merits. The tax assessment process, including required guarantees and settlement procedures, needs to be reformed through legislation to provide more transparency and fairness.
Similarly, the authors believe, the government's formal audit review process needs to be reformed to correct unfairness in light of frequent changes in the personnel involved in audit inspections, as successor inspectors sometimes hesitate to agree to reasonable settlements that result in a lower burden to the taxpayers than originally communicated by their predecessors. The successors react this way because of an internal review process within the tax authority that could invoke personal responsibilities for them. Reforms should permit expeditious and practical negotiations for the mutual benefit of the government and taxpayers.
Article 109 of the Federal Tax Code deals with simulation. The article provides that tax fraud is a criminal act and includes the simulation of one or more acts or contracts whereby the taxpayer obtains an undue tax benefit. The term “simulation” is not defined in the Federal Tax Code. However, Article 2180 of Federal Civil Code defines simulation as an act whereby the parties declare or falsely confess to something that has not actually occurred or has not been agreed to by the parties. It is the experience of the authors that the act of simulation rarely, if ever, occurs in the context of large multinational organizations and, frankly, it is difficult for the tax authorities to prove because they must determine the intent of the parties. But taxpayers' fear of a simulation charge always overshadows legal structuring.
This analysis of simulation is further complicated by a new provision in Article 213 of the MITL, effective in 2008, with the following provisions (freely translated):
For purposes of this Title and the determination of Mexican sourced income, the tax authorities may determine the simulation of the juridical acts exclusively for tax purposes as part of the procedures applied during its audit inspection process. The determination of simulation must have the appropriate technical support and must be properly documented as part of its determination according to the requirements of Article 50 of the Federal Tax Code, for juridical acts conducted between related parties.
For purposes of establishing simulation, the factual determination shall be that which was effectively realized by the parties.
The resolution in which the authority determines the simulation must include the following:
a. Identify the simulated act and that which was actually agreed upon
b. Quantify the benefit received by virtue of the simulation, and
c. Document the elements considered for determining the existence of such simulation, including the intention of the parties to simulate the act.
The main significance of Article 213 is that the tax authorities are now empowered to assert simulation and thus to recharacterize the tax treatment of transactions for transfer pricing and other tax purposes, apparently independently of the criminal justice system.
For example, the tax authorities could attempt to reclassify a valid loan transaction as a capital transaction, notwithstanding the regular limitations under the MITL (e.g., thin capitalization or back-to-back loan rules).
Characterization vs. Recharacterization
In analyzing substance over form, a distinction should be made between characterization and recharacterization. Characterization refers to the legal status of a transaction. For example, repayments to the creditor that is party to a valid legally enforceable loan agreement should be “characterized” as principal and interest. If the loan were “recharacterized ” as an equity investment for tax purposes, the payments might be considered dividends or reimbursement of capital.
In general, transactions should be characterized according to the legal status of the transactions for tax purposes. Nevertheless, the tax authorities may believe that transfer pricing concepts could operate to recharacterize the status of transactions legally structured as loans solely for tax purposes, according to their economic substance, not limiting adjustments to the mere change of the interest rate, assuming local legislation can recharacterize such payments. 7
7 OECD transfer pricing guidelines, paragraph 1.37.
As previously mentioned, specific legislation applies to recharacterize interest on back-to-back loans as dividends. Moreover, in the case of individuals, the last paragraph of Article 165 of the MITL provides that any transfer pricing adjustments between related parties shall be classified as dividends. If the tax authorities can establish that an arm's-length loan instrument would not be granted under conditions similar to those of the controlled transaction, but rather would be agreed upon only as an equity instrument given the credit standing of the debtor, Article 165 arguably could serve to recharacterize interest as dividends, notwithstanding the use of an “interest rate” consistent with partial market conditions. The treatment of transfer pricing adjustments for taxpayers other than individuals is not clear.
It is important to note that the recharacterization of excess payments for transfer pricing purposes as dividends could result in a reduction of the After Tax Earnings Account (“CUFIN,” the Spanish acronym). Moreover, if there is not enough CUFIN to cover the distribution, it could be considered a taxable distribution by the payor and taxed at the rate of 38.89%.
In the past, the form of a transaction was more important than its substance, but Mexican legislation has evolved to address substance-over-form issues in many respects. Nevertheless, there are still traps for the unwary when the form of a transaction is not adequately considered. This requires more attention to ensure that there are non-tax business purposes for transactions and that the treatment and the transfer pricing reflects economic substance, while complying with the formalities and related documentation.
Many restructurings are being challenged on the basis of transfer pricing, which is essentially driven by economic substance. In this connection, the transfer pricing legislation needs more specific and detailed guidance to provide more certainty to the tax system in Mexico. In addition, Article 213 of the MITL and Article 109 of the Federal Tax Code should be clarified and restricted to specific situations.
Pro rata allocations and cost-sharing arrangements are acceptable under the OECD transfer pricing guidelines, and Mexican legislation should be congruent in every respect with those guidelines. The authors recommend that the legislation be revised to permit charges based on allocations from related parties abroad, in appropriate circumstances. Significant regulatory guidance is needed on the application of the arm's-length principle, consistent with guidance issued by other countries, such as the United States.
Moreover, the assessment procedures, including those for required guarantees and settlements, need to be reformed to bring more transparency and fairness into the process.
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