David Cuellar, Mario Alberto Gutierrez, Luis Angel Campos and Carlos Montemayor
Having made minimal tax reforms for 2011, Mexico is expected to implement important changes for 2012. One possibility, David Cuellar, Mario Alberto Gutierrez, Luis Angel Campos and Carlos Montemayor of PwC report, is the elimination of the flat tax, or adding some of its elements to the income tax, in an attempt to boost the internal economy.
The 2011 report of the OECD stated: "…following a deep recession associated with a strong global downturn, Mexico is experiencing a robust recovery, with a Gross Domestic Product (GDP) growth of five and a half per cent in 2010 and four and a half per cent in 2011…", partly as a result of the fiscal and economic policies implemented by the government in this period; nonetheless, the OECD also recommended that Mexico does not continue to depend on the volatile price of oil and that a major tax reform to increase its tax collection and avoid a recession in periods of lower oil sales should be implemented.
In the last quarter of 2007, Mexico announced the most important tax reform of recent years: the flat tax or IETU (its Spanish acronym) and the abolition of the Mexican Asset Tax. The flat tax has been part of the Mexican taxation system since January 1 2008, as an anti-avoidance response to what are considered by the Mexican tax authorities to be "improper tax practices". In addition, according to the transitory rules of the flat tax legislation, the Ministry of Finance and Public Credit (SHCP – its Spanish acronym) has concluded a general assessment on the advisability of removing the chapters regarding legal entities and individuals in the income tax legislation, so that the tax regime applicable to these taxpayers can be regulated solely by the flat tax.
In this regard, with arguments for the permanence of the flat tax, and almost appearing as an ideal and seamless tax, the SHCP provided a comprehensive assessment of it, three years from its implementation. The conclusions of the SHCP are that the validity of the flat tax has been rather short, so it is necessary to allow its maturation and to continue to analyse it, without prejudice. The SHCP will continue to monitor its evolution.
As can be seen, for a few years the elimination of the tax system and the evolution into a new one has been considered. All the above sustains the basic premise that Mexico's tax system needs to be overhauled.
Following the Mexican government tendency of making important changes to the tax legislation one year and immediately following with a year of minimum changes, subsequent to the 2010 consolidation tax reforms, the minor tax changes for the 2011 fiscal year are described here:
2011 tax reforms – significantly less change than in 2010
The proposed tax reforms, due to take effect from January 1 2011 are few, compared to those of 2010 which had a significant impact on Mexican taxpayers, with tax rate increases and the recapture of tax deferred through tax consolidation becoming payable suddenly in many cases.
A new rule that is in force as from 2010 is the incentive for theatrical productions; the rules regarding this tax incentive are similar to the cinematographic incentive already established in the Mexican Income Tax Law (MITL), and in general terms it considers the amount of the production investment as a creditable item against income tax, applicable to both the annual tax calculation and the estimated monthly payments. This incentive is limited to 10% of the income tax liability of the previous tax period. If the tax credit is higher than the income tax of the year, the difference can be carried forward for the next 10 years, until it is totally applied.
The total amount of tax credit to be distributed between the applicants would not be more than Ps50 million ( $4.3 million) a year, but again limited to Ps2 million for each taxpayer and investment project. This incentive is foreseen to have an effective lifetime of three years.
Another tax rule that was included in the 2011 tax reform bill is the one related to the first job additional deduction available for employers who hire first-job employees for newly-created positions. Under this rule, an additional deduction is calculated using a specific scheme. Through this tax incentive, the Mexican government expects to promote employment and reduce the level of unemployment. This deduction is applicable both for advance tax payments and for the annual tax return. To apply this rule, the employer should comply with all social security obligations, and filing of the corresponding informative tax returns and a specific notification before the Mexican tax authorities. This deduction should not be considered as part of the calculation for the profit sharing and the profitability factor for advance monthly tax payments. Also, it is limited to the minimum wage of the geographical area times eight (about $1.20 monthly).
Taxpayers taking the deduction but not meeting conditions outlined by the Mexican tax authorities will be requested to pay the tax that would have been due, including any interest charges, and will not be permitted to take the deduction in future tax periods. The newly-created job positions would be those that increase the number of employees that the taxpayer has registered with the Social Security Institute. The new position must exist for a minimum of 36 months from its creation and be occupied (for at least 18 months) by the first-job employee for that time.
Once the 36 months are up, the job position will no longer carry the income tax benefit. If an employee falling within the definition of a new position leaves the company during the qualifying time period and is replaced by another first-time employee, the taxpayer can still benefit from the deduction for the newly created position.
Also, for 2011, the income tax withholding rate on interest paid to banks registered in Mexico and residing in a country with which Mexico has a tax treaty in force will be of 4.9%, as it has been established for several years.
Concerning the flat tax, when the result is a tax credit in favour of the taxpayer, for having higher deductions than income under its own rules, this credit shall not be applicable against the income tax of the year, but only against the flat tax payable over the next ten fiscal years. This limitation once more is repeated for 2011, 2010 being the first year where the Mexican government limited its application. At that time, it was not fully clear whether this would be a one-time limitation or if it would turn into a general limitation, which now seems to be the case.
Regarding excise taxes (Special Production and Services Tax or IEPS – its Spanish acronym), the rates on cigarette sales and imports were increased. The Mexican government and the legislative branch, say that this increase reflects the need for greater tax resources to deal with the costs that cause smoking-related diseases. These bodies have also been pushing to create taxes on food they consider to have high calorie content. Now, the sale or importation of energy drinks (and powders or concentrates to make them) will be subject to excise tax at a new 25% rate.
In this regard, energy drinks are defined as non-alcoholic drinks with more than 20mg per 100ml of caffeine and mixed with stimulants such as taurine, glucuronolactone or thiamine. This initiative has also arisen in relation to health concerns over high consumption of such drinks, with high quantities of ingredients such as caffeine and taurine.
Also, most of the annual tax incentives of 2010 have been renewed, among others, the credit against the income tax of the excise tax paid for the acquisition of diesel that is destined for consumption, of certain sectors.
Amended Maquiladora decree
Mexico relies on the Decree to Promote the Manufacturing, Maquiladora and Export Services Industries Program ( IMMEX Decree) to create a favourable environment for foreign investment in its manufacturing sector. In a nutshell, the special tax regime for the Maquiladora industry includes the exemption of a permanent establishment in Mexico for foreign residents that have a contractual relationship with the Maquiladora, if certain rules are satisfied (for example, safe harbour transfer pricing methods).
Changes made to Mexico's IMMEX Decree that became effective on January 1 2011 impose new limitations on the income tax and flat tax benefits available to Maquiladoras. Article 33 of the decree was amended to include the new requirements that must be met by Maquiladora operations to benefit from the special tax regime that is only available for the Maquiladora industry.
One of the conditions regarding raw materials is that they must be supplied directly by the foreign entity and are considered to be owned by that entity and must be imported on a temporary basis by the Maquiladora company and returned abroad. This rule also applies to virtual exports (this is, where the importer legally exports the goods without an actual physical export). This situation is now clarified under the amended decree.
Another change to the Maquiladora regime is the requirement for foreign entities to own at least 30% of the Machinery and Equipment (M&E) used in the Maquiladora operation. From January 1 2011, the M&E used by Maquiladoras operating under an IMMEX programme must be at least 30% owned by the foreign resident/principal, and must not have previously been owned by the Maquiladora or by a Mexican resident entity that is related to the Maquiladora.
However, the M&E used in the Maquiladora's operations may be owned by:
- a third-party foreign resident, with which the Maquiladora has a commercial manufacturing relationship, and when the M&E is provided as part of this relationship; or
- an unrelated party which leases the M&E to the Maquiladora. In either case, the M&E may not have been previously owned by another Mexican resident entity that is related to the Maquiladora. This M&E rule does not apply to Maquiladoras that were already operating under the IMMEX programme, as of December 31 2009 if those Maquiladoras comply with transfer pricing and related safe harbour profit margin rules for Maquiladoras. In case this threshold is not satisfied the ability to secure any Maquiladora tax benefits will not apply.
Other relevant rules during the first half of 2011
So far, some of the main rules published are the ones about the information that has to be filed with the Mexican tax authorities as part of the administrative facilities Presidential Decree, upon the election of not filing the statutory tax report.
In general terms, though the number of annexes is rather reduced, the detail of information of such annexes is still significant. In light of this, taxpayers are still likely to file the full statutory report and benefit from the additional features that such obligation conveys, such as the sequential review carried out by the Mexican tax authorities.
Also, the rules to determine the M&E proportion (that is, 30% as mentioned above) according to the new Maquiladora framework need to be disclosed.
Lastly, the reform made to the Mexican Federal Tax Code regarding the issuance of digital tax invoices, has come into force on January 1 2011. Such reform establishes the obligation for taxpayers to issue digital tax invoices online. It also specifies that taxpayers who acquire, use or enjoy goods, or use the services must request the corresponding tax invoices. Specific transitory rules on this matter have been issued through several administrative rules and by postings on the Mexican Tax Authorities' website.
IRS expects resolution on flat tax creditability in 2011
The basics of the foreign tax credit regime in the US are governed by the Internal Revenue Code sections 901 and 902 and allows for both a direct and an indirect foreign tax credit for tax payments. Under these rules, the requirement that the tax be on income is causing the most concern with respect to the flat tax, since the regulations provide that for a tax to be deemed to be on income, it must have the predominant character of an income tax in the US sense, meaning that the foreign tax is likely to reach net gain and is not a soak-up tax (that is, a tax liability that depends on the availability of a credit).
Furthermore, the regulations provide a net income test that requires that the foreign tax allows for the recovery of significant expenses incurred creating the income. However, a foreign tax that does not permit recovery of one or more significant costs or expenses, but provides allowances that effectively compensate for the non-recoverability of such costs or expenses, is considered to permit recovery of such costs.
Based on the above, the flat tax causes creditability concerns, since deductions for interest are disallowed, as are deductions for royalties paid between related parties and deductions for some employee benefits. The disallowance of those deductions causes concern that the net income test is not being met. This would mean that US investors may not be able to receive a credit against their US income taxes for the flat tax paid in Mexico (that is, generating double taxation).
Even so, on December 10 2008, Notice 2008-3 was issued by the IRS, in which the US tax authorities established that it had not determined whether the flat tax qualified as an income tax and that the agency was going to study the new tax to make a determination. Most importantly, the agency said that if it determined later that US taxpayers were not entitled to a credit against the flat tax paid in Mexico, claimed credits for payments or accruals of flat tax made before the determination and anytime during the tax year that the determination is made would not be challenged by the agency.
The US government is looking at the flat tax in the context of its foreign tax credit statutory regime, the regulations, US case law and IRS pronouncements and is expected to step in with a final clarification sometime during this fiscal year.
Mexico's tax treaty scene for 2011
Recently, Mexico has been active in the negotiation of several tax treaties and renegotiation of several others.
The new treaties with India, Panama, South Africa, Switzerland (a renegotiated protocol) and Uruguay have been in force and are applicable as of January 1 2011.
During 2011, the tax treaties negotiated with Colombia and Kuwait have been approved by the Mexican Senate. Also, Mexico has signed new treaties with Peru, Bahrain, Hungary and Venezuela, which are pending approval by the Mexican Senate. On the other hand, the amendments to the tax treaty with Luxembourg and UK, through the issuance of a new protocol, has been already approved by the Mexican Senate in Mexico and published in the Mexican Official Gazette.
As of June 2011, Mexico is in the process of negotiating tax treaties with Hong Kong, Latvia, Lithuania, Lebanon, Malaysia, Malta, Monaco, Morocco, Nicaragua, Pakistan, Qatar, Slovenia, Thailand, Turkey and Ukraine.
The Mexican tax treaty network is comprised of treaties with 41 countries: Australia, Austria, Barbados, Belgium, Brazil, Canada, Chile, China, Czech Republic, Denmark, Ecuador, Finland, France, Germany, Greece, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Republic of Korea, Luxembourg, Netherlands, New Zealand, Norway, Panama, Poland, Portugal, Romania, Russia, Singapore, Slovak Republic, South Africa, Spain, Sweden, Switzerland, UK, US and Uruguay.
Tax reform proposals for 2013
In March 2011, the Mexican Congress through the Senators Gazette delivered a tax reform proposal (signed by Senator Manlio Fabio Beltrones as representative of the institutional Revolutionary Party, also known as PRI) focused on modifying the MITL and the Value Added Tax (VAT) Law. The relevant facts of this proposal include the repeal of the flat tax law and the subsequent incorporation of certain concepts included in the flat tax law to the MITL, as well as important changes under the VAT Law. If approved by the Congress, these measures would most likely apply from January 1, 2013. A few items that are worth highlighting from this proposal are:
- The taxable income would be calculated on a cash flow basis rather than an accrued basis.
- The corporate income tax rate would be gradually reduced from 30% to 25% (30% in 2012, 27% in 2013, 26% in 2014 and 25% in 2015). Individual tax rate would be increased from 30% to 35%.
- Dividends paid out of the CUFIN account would be taxed at a 10% rate, but those not paid out of the CUFIN account would be taxed at a 35% rate (an extra 10% tax would be paid). This model resembles the Chilean one for dividend distribution where in addition to the 17% corporate tax rate, an entity must pay a tax (either the global complementary tax for individual residents or the additional withholding tax for non-resident entities and individuals) upon the distribution of profits. The basis of this rule is to promote the reinvestment of profits within the country.
- An optional tax regime would apply to entities that are wholly owned by Mexican tax residents and whose annual income in the previous fiscal year is below a certain threshold (rather for small companies). Such entities would be able to elect to pay a flat 5% income tax rate on all taxable income earned during the year, but no deductions would be allowed. A similar regime with a 3% rate would be available to entities engaged exclusively in agricultural activities, also limited to certain threshold of revenues. This sort of simplified tax regime would be in essence similar to the Brazilian Super Simples tax regime, which authorises companies with annual gross revenues of up to R$2.4 million ($1.3 million) to pay a single tax instead of the regular federal, state, and municipal Brazilian taxes.
- The disallowance of deductions for royalty payments and wages and salaries paid to employees, would be transferred to the MITL, thus retaining these limits on deductions, though incorporating a credit similar to the one under the flat tax on salaries and wages.
- Only a general VAT rate of 16% would apply. The zero rate would be applicable only to specific goods.
- A VAT refund of 3% would be applicable to individuals that acquire goods and services from formal suppliers.
The Mexican government has expressed a desire to provide stability to taxpayers, after the 2010 major reforms that increased income tax and VAT rates in the context of a global crisis.
"We explained that Mexico is a safe destination for investment, with ideal conditions for doing business," Felipe Calderon, President of Mexico, told reporters at the World Economic Forum in the Swiss resort of Davos, at the beginning of the year. Ernesto Cordero, the finance minister, also expressed that "as little by little we resolve our security problem, Mexico is going to become more attractive than it already is".
In the tax arena, Cordero, who is running for his party's nomination for President of Mexico, recently defended keeping the flat tax in the future. "The flat tax has been a good tool for collecting tax", he said.
As can be seen, the 2011 Mexican tax reform could be considered to be immaterial and will not considerably increase tax collections in Mexico as a percentage of the GDP. However, the political environment that will surround 2012 due to the electoral period will have a direct impact on economic, legislative and governmental perspectives. The hope is that all the tax ramifications that will come from this period will be for the best of the country.