Mexico 2020 tax reform: big changes proposed for foreign companies doing business in Mexico

By Fernando Juarez Hernandez, International tax attorney, Cacheaux, Cavazos & Newton, L.L.P

On September 8, the executive branch of the Mexican government introduced Mexico 2020 tax reform, proposing far-reaching changes to the Mexican income tax, value-added tax, and Federal Tax Code.

Although previous Mexican government tax reform efforts have been aimed at highly digitalized businesses, Mexico 2020 tax reform goes beyond these goals, proposing modifications that change the entire international Mexican tax system.

The amendments are designed to address concerns highlighted by the OECD/G20 base erosion profit shifting (BEPS) project. Included are updates to the concept of permanent establishment, modifications to the tax treatment of payments made to hybrid entities, and new limits on interest deductibility.

The tax reform also includes the implementation of an anti-avoidance provision, introduces mandatory disclosure of tax structures by tax advisors, and allows the use of tax information provided by third-party informants.

Who is affected?

International companies doing businesses in Mexico should be vigilant. Companies particularly affected by the reform include those that receive payments from Mexico, such as interest; companies making payments to controlled foreign corporations; and structures that use tax-transparent entities.

International companies doing businesses in Mexico should be vigilant. Companies particularly affected by the reform include those that receive payments from Mexico, such as interest; companies making payments to controlled foreign corporations; and structures that use tax-transparent entities.

Additionally, under the Mexico 2020 tax reform, businesses using digital platforms (including nonresident taxpayers) would be subject to registration in Mexico and must withhold taxes from users.

Finally, with the introduction of an anti-abuse rule, the creation of third-party informants, and mandatory reporting of tax structures by tax consultants, the tax reform will impact all types of taxpayers.

Permanent establishment changes

One of the most important changes is to the permanent establishment concept. Under current rules, generally, a permanent establishment is created when a nonresident either has a fixed place of business in Mexico or operates in Mexico through a dependent agent.

Under Mexico 2020 tax reform, the concept of permanent establishment would be extended to include third parties that are not agents of the nonresident but who conclude or enter agreements on behalf of the nonresident. A permanent establishment would also be created when a third party concludes agreements that bind a nonresident to provide a service.

A permanent establishment is not created if these activities are auxiliary. However, if the activities are a complement to a “single business structured transaction,” then the activities will create a permanent establishment. The proposed rules are designed to tackle planning strategies involving the fragmentation of operations to avoid a permanent establishment.

Similarly, the concept of agent is updated in Mexico 2020 tax reform. Under the proposed rules, an agent will be presumed to be dependent (therefore creating a permanent establishment), when such person acts exclusively or almost exclusively on behalf of a nonresident related party.

It must be noted that the presumption will only apply in cases involving related parties. This update will surely cover tax strategies used by nonresidents that remotely serve customers in Mexico from a foreign jurisdiction while establishing a local subsidiary (so-called “trade structures”) that is responsible for facilitating sales (e.g., by providing marketing services).

Transparent entities

 To avoid the use of strategies involving transparent entities, Mexico 2020 tax reform provides that transparent foreign entities will be considered a separate taxable entity.

For these purposes, the concept of foreign entities includes persons that have separate legal entity (e.g., a corporation) as well as those that do not (e.g., joint venture).

Such foreign entities will be deemed to be transparent if they meet two requirements. First, they must not be tax residents for income tax purposes in the jurisdiction where they were incorporated or where their effective place of management is located. Second, their shareholders, members, or similar personnel must receive the income attributed to those entities.

Foreign tax credit, interest deductibility

 Mexico 2020 tax reform includes several provisions addressing various BEPS concerns. For example, the foreign tax credit is not allowed in cases involving the distribution of dividends when such dividends are a reduction for the nonresident that distributes them.

Another important change is related to the deduction of interest payments. Under the new rules, net interest in excess of the amount resulting from multiplying net income by 30% is not deductible.

The reform provides a de-minimis exclusion of the first 20 million MXN pesos (approx. USD 1 million). The nondeductible excess can be carried forward for the next three years.

Digital economy

Mexico 2020 tax reform includes a new proposal to tax highly digitalized businesses. It must be noted that currently there are two other proposals that have been introduced in Congress (on August 21, 2019, and September 5, 2019) aiming to tax businesses of this type.

Despite the existing proposals, Mexico 2020 tax reform introduces a more comprehensive approach to taxing highly digitalized businesses.

For income tax purposes, the tax reform clarifies that taxpayers who obtain income from using a digital platform, software, or similar technologies must pay income tax.

For income tax purposes, the tax reform clarifies that taxpayers who obtain income from using a digital platform, software, or similar technologies must pay income tax.

Thus, digital platforms will act as collection agents and must withhold the respective amount of income tax in accordance with withholding tax rates provided by the reform.

For VAT purposes, digital services are deemed to be provided in Mexico (and thereby taxable) if the recipient is located therein. The concept of digital services includes intermediary platforms; services like downloads of audio, video or images; online dating sites; data storage; or distance learning services, among others.

Under the Mexico 2020 tax reform, platforms must register in the Mexican taxpayers’ registry (including nonresidents), withhold the respective amount of income tax, keep accounting records, charge VAT on users’ transactions, appoint a legal representative, and establish a domicile in Mexico to receive notices (it is worth mentioning that such registration does not create a taxable presence in Mexico).

If a nonresident with no taxable presence in Mexico fails to comply with these obligations, the company will not have access to Mexican customers. Mexico 2020 tax reform proposes a process where connectivity through telecommunications networks will be interrupted until such nonresident registers in Mexico.

Tackling aggressive planning

The tax reform also includes amendments to strengthen the tax authorities’ resources to attack aggressive tax planning and avoidance.

Two main instruments are implemented in the proposal. First, an anti-abuse rule is introduced which allows the tax authorities to question transactions that have no business purpose and that are entered into only for a tax benefit.

This provision mirrors elements from US case law, such as the introduction of the step transaction doctrine.

As a complement to this rule, Mexico 2020 tax reform introduces a regime for mandatory disclosure reporting.

This regime mandates that tax consultants reveal any structure that provides a tax benefit (e.g., a deferral, among others). In some cases, consultants must disclose the names of their clients.

Mexico 2020 tax reform – some thoughts

As described, Mexico 2020 tax reform introduces several changes to the Mexican international tax system. Foreign companies doing business in Mexico must be aware of this new legislation and should analyze current structures to avoid unpleasant surprises.

The broad terminology of provisions taxing highly digitalized businesses is concerning due to the impact it will have on traditional businesses who now have an online presence.

All these aspects must be analyzed carefully to assess the impact on cross-border transactions. Mexico 2020 tax reform draws inspiration from the OECD’s work and we must be vigilant on how these changes are implemented in Mexico.