Mexico transfer pricing comparability adjustments, the search for consensus

By Jesús Aldrin Rojas, Partner, QCG Transfer Pricing Practice, Mexico City

Government officials and transfer pricing practitioners gathered in Mexico City on 15 January to discuss new transfer pricing guidance that will have significant implications for multinationals conducting business operations in Mexico.

The event, held at the Universidad Panamericana Campus Mixcoac, was organized in response to publications issued by the Mexican tax authority, the Servicio de Administración Tributaria (SAT), on 21 November 2018, called “Clarifications with regard to frequently asked questions in relation to the implementation of transfer pricing comparability adjustments”, and on 30 november 2018, “Non binding criteria”, specifically the criteria 39/ISR “Recognition of unique and valuable contributions” and 40/ISR “Modifications to the value of related party transactions within the interquartile range”. 

The forum had in attendance technical experts from the Commission on Transfer Pricing of the National Federation of Economists, who, through various panels, analyzed the implications of the position taken by the SAT.

The SAT was represented by Carlos Pérez Gómez Serrano, Central Administrator on Transfer Pricing Taxation, and by Óscar Fernando Trujano Sandoval, Transfer Pricing Administrator, who, with great enthusiasm, provided their point of view and debated each of topic submitted for review.

The following is a summary of the proceedings.

Mexico transfer pricing comparability adjustments

A panel on transfer pricing comparability adjustments had the participation of Carla Herrera of Élan Zaak, Argel Romero of BDO, Allan Pasalagua of Baker McKenzie, Édgar Antúnez of PwC, and Marisol Oregel of RSM as moderator.

The panel analyzed basic concepts, such as comparability (two or more transactions with comparables, for transfer pricing purposes, so long as there are no significant differences that could affect the price or margin being tested by the selected method). The panel examined the type of transfer price comparability adjustments that can be applied and considered whether the comparability adjustments could indeed improve the transfer pricing analysis or if they would distort the comparison once they are applied.

Finally, the panel evaluated the significant differences that may have an impact on the price, and therefore could be explicitly identified and eliminated through the application of the adjustment, as well as those differences that are non-significant, either due to their lack of materiality or impact in the transfer pricing analysis method employed.

Subsequently, the panel elaborated on certain comparability adjustments that are typically applied in Mexican transfer pricing, in particular those related to working capital.

It is necessary to consider that, during the application of transfer pricing methods based on profitability, such as the resale price method, cost-plus method, or transactional net margin method, working capital adjustments are generally carried out through the estimation of the differences between the analyzed entity and the comparable. Accounts receivable, accounts payable, and inventory, could affect the profitability of the entity holding them, and the differences, should they exist, must be quantified and eliminated.

On this topic, in particular, the panel reviewed adjustment formulas used to eliminate the differences in working capital proposed by the Mexican government, and those proposed by the OECD in its 2017 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The panel identified percentage differences among the different approaches and highlighted the need to adequately establish the interest rates that must be employed to implement said adjustments in response to the cost of the capital of the comparables.

Mexico’s proposed country risk adjustment

This panel had the participation of Carlos Pérez Gómez Serrano, Central Administrator of Transfer Pricing taxation of the SAT, Ricardo M. Cruz Sánchez of EY, Miguel A. Trejo López of Andersen Tax & Legal, and David S. Barrón Tovar of LawBiz Consulting Group, and had Jesús Aldrin Rojas of QCG Transfer Pricing Practice as the moderator.

This discussion centered around the SAT’s proposal to apply a “country risk” adjustment, as well as some possible alternatives. From the point of view of the tax authorities, when taxpayers utilize transfer pricing methods that compare profitability margins (gross or operating) of the tested party to those obtained by independent third parties, particularly comparable companies from developed economies (like the US), it is necessary to apply an adjustment that considers the impact on profitability of the comparables had these been carried out in the country of the tested party (In this case, Mexico).

The transfer pricing adjustment proposed by the SAT uses article 179, third paragraph, of Mexico’s income tax law (LISR) as support for its position, which states:

“[I]t is understood that the operations or companies considered comparable to the analyzed operation are so when there are no differences among them that could significantly affect the price or amount of the consideration or profit margin mentioned in the methods provided in article 180 of said normative, and when these differences exist, they can be eliminated through reasonable adjustments”.

The Mexican tax authorities have proposed the elimination of the differences in profitability attributable to the operation in countries with different country risk according to the following formula:

ACR = AOAComp * CRMexico
ACR = Adjustment for country risk
AOA = Average operating assets of the comparable
CR = Country risk in Mexico
Application
SalesComp + ACR/strong

As one can see, the main factor in this formula is the country risk adjustment which quantifies the possibility of default in the obligations of an emerging country vs another, typically the USA. The EMBI –index elaborated by JP Morgan- (emerging market bond index) represents the difference in interest rates from bonds denominated in dollars, emitted by emerging countries, to US Treasury bonds, that are considered “free” of risk as expressed in base points. Next, the following was shared with the authorities:

• Paragraph 3.53 of the OECD Transfer Pricing Guidelines states: “it is not appropriate to consider certain comparability adjustments routine and indisputable…The only adjustments that must be made are those that are expected to improve comparability.”
• The profitability of companies does not necessarily show behavior linked to EMBI. From the economic point of view, there is no positive correlation between risk and performance in the context proposed for this adjustment.
• The proposed adjustment, if it were applied in all cases, would increase the profitability of the comparables and does not consider, in detriment to the taxpayer, an eventual negative exposure of risk that could potentially lead to losses.

This panel analyzed some alternatives for the country risk adjustment:

• Search for comparable companies in economies similar to Mexico
• Invert the analyzed party (with regards to additional available information)
• Evaluate the viability of the country risk adjustment in a case-by-case basis through a quantitative approach that confirms the correlation between risk-performance in the industrial or services sector where the taxpayer participates

Adjustments within the interquartile range

This panel had the participation of Mario Barrera of Thomson Knight, Ricardo Cruz of EY, Guillermo Villaseñor of Sánchez Devanny, Óscar Trujano of the SAT, and moderated by Yessica Valor of Best Buy. It analyzed the implications of criteria 40/ISR/CNV “Changes to the value of operations within the interquartile range”.

As a reference, it is necessary to consider the application of the transfer pricing methods in article 180 of the LISR result in an interquartile range (derived in terms proposed in numeral 302 of the Federal Tax Code regulations, RCFF) that represents the prices or profit margins that, in the opinion of the taxpayer, third parties would have obtained in comparable operations. The SAT states the following:

Article 180 of the LISR, fractions I and VI, establish the methods to determine the prices for the operations with related parties. The second paragraph dictates that from the application of any of the methods, the analysis may derive a range of prices, amounts, or profit margins when there are more than two comparable operations, and will adjust through the application of statistical methods, and should the taxpayer’s price, amount, or profit margin be within this range, said prices, amounts, or margins will be considered as if they would have been carried out among independent parties. In the case that the taxpayer is outside the adjusted range, the prices, amounts, or margins will be considered to be the median of said range (transfer pricing adjustment).

For its part, article 302 of the RLISR indicates that for effects of article 180, second paragraph of the LISR, the range of prices, amounts, or profit margins may be adjusted through the application of the interquartile method and also mentions that if the prices, amounts, or profit margins of the taxpayer are within the percentile 25 and 75 set in this statistical method, these will be considered as if they would have been carried out among independent parties.

Given the previous one can infer that a transfer pricing adjustment is only valid should the taxpayer be outside of the interquartile range of prices, amounts or profit margins of independent parties.

Transfer pricing adjustments exist only when the tested party is outside the interquartile range corresponding to the tested operation. In this case the adjustment will be to the median of said range. It is not prudent to modify the tested party price, amount, or profit margin should it be within the range, as the adjustment will not be intended for the compliance of the applicable tax law, and instead intends to increase the income or deductions of the domestic taxpayer potentially affecting its taxable income.

It follows that there is no legal basis to carry out any additional modifications to the prices, amounts, or profit margins when these are within the adjusted ranges derived for the interquartile method. In contrast, the transfer pricing adjustment stated in normative 3.9.1.1 is only applicable when the prices, amounts, or profit margins, already adjusted by a statistical method, are outside the range mentioned in article 180, second paragraph, of the LISR or article 302 of the LISR regulation.

From said criteria, it follows that the Mexican tax authorities consider the revalorization of transactions that already were within the parameters proposed by the interquartile range to outlying points in the range as an inadequate tax practice, to maximize intercompany income or deductions, except in cases established by the criterion itself.

Neglecting the criterion may result in the disallowance of the transaction for the taxpayer, that may affect its taxable income. During the technical discussion of the panel, there were several considerations made in relation to the temporality of this type of operations and the effect that could they could have given the position of the tax authorities.

The panel concluded that, in principle, the adjustments within the range are allowed only if they are made before the close of the fiscal year, but if these are carried out between the 1 January and 31 March deadline to present the annual declaration, they would have to observe the Miscellaneous Tax Rules, RMF 3. 9.1.1. to 3.9.1.5.

The tax authorities noted that adjustments made after the annual declaration deadline must consider the effect that these may have in eroding the tax base of the taxpayers.

Likewise, the panel foresaw the need to present the informative declaration of relevant operations in cases mentioned in format 76 “declaration of relevant operations” and in attention to the rule 2.8.1.17 of the RMISC.

Unique and valuable contributions

The last panel comprised of Fernando Pliego of Grant Thornton, Yoshio Uehara of Chévez Ruiz Zamarripa, Jesús Aldrin Rojas of QCG Transfer Pricing Practice, Óscar Trujano of the SAT and Guillermo Villaseñor of Sánchez Devanny as moderator.

 This panel analyzed criterion 39/ISR/CNV, as follows:

Recognition of unique and valuable contributions. The contributions made by a Mexican taxpayer to a multinational group (in such a case) must be recognized in the transfer pricing analysis to demonstrate that the transactions with related parties, the accruable income and authorized deductions were determined by considering for these operations the prices or amounts that would have been used with or among independent parties in comparable operations.

Articles 76, first paragraph, fractions IX and XII; 76-A, fraction II and last paragraph; 90 penultimate paragraph; 110, fraction XI and 179, first paragraph of the LISR mentions that should the taxpayer carry out operations with related parties, these must determine their income and authorized deductions considering the prices or amounts that would have been used with or among independent parties in comparable operations.

For such purposes, article 180 of the LISR dictates the methods that must be employed by the taxpayer: uncontrolled price method, resale price method, cost-plus method, profit split method, residual profit split method, and the transactional net margin method.

Article 180 also mentions that the application of one of these methods could yield a range of prices, amounts, or profit margins when there are two or more comparable operations. These ranges can be adjusted through the application of statistical methods.

Additionally, the third paragraph of article 179 of the LISR states that operations or transactions are comparable when there are no differences among these that could significantly affect the price, amount, or profit margin as stated in article 180 of the LISR and should these exist they can be eliminated by applying reasonable adjustments; and in order to determine said references the functions or activities, including assets used and risks assumed in the operations of each of the related parties involved in the transaction shall be considered, as well as others specified in the third article of 179. Likewise, the last paragraph of article 179 establishes that the OECD Transfer Pricing Guidelines are applicable for the interpretation of the stated in the LISR regarding multinational entities so long as they are consistent with the law.

According to the OECD Guidelines, the analysis of the functions, activities, risk, and assets, of taxpayers that carry out operations with related parties must identify and evaluate valuable contributions. These intangibles are understood as those whose conditions and business attributes generate value that would increase future economic benefits in a manner that would not occur had they not exist, such as created or utilized intangibles, or comparability criteria that define any business advantage, including research activities, and/or improvement, maintenance, projection or exploitation of intangibles.

In this sense, if the application of the methods established in Article 180 of the LISR [in particular during the comparability analysis] identifies differences between the controlled transaction and its proposed comparables due to unique and valuable contributions and those differences affect the price or the Consideration amount or profit margin referred by the aforementioned methods, it would be technically incorrect to consider the operations or companies referred to as comparable. By virtue of the above, to give symmetry to the comparison of operations, taxpayers must consider their unique and valuable contributions, as well as those of the companies with which they are compared.

Inadequate tax practices are:

1. 1. The taxpayer does not recognize its own unique and valuable or those of the comparable companies in its transfer pricing analysis.
   2. The taxpayer considers operations or companies as comparables even when there are significant differences among them and the tested transaction due to unique and valuable contributions.
   3. Assess, counsel, provide services, or participate in the realization or implementation of the previous practices.

The panel began by presenting the circumstances that drove the authorities to publish the non-binding criterion. In particular, the panel highlighted the need for the taxpayer to implement a comparability analysis in which they can effectively account for the organizational deployment of its entities at a transactional level (with special attention to the regulatory framework of actions 8-10 of the BEPS action plan) and that this comparability analysis results in the selection of entities that can truly be considered as a benchmark to validate the arm’s length condition of the operations subject to analysis.

In this session, the emphasis was that the taxpayer, during the elaboration of the functional analysis, should identify unique and valuable contributions from non-routine activities (typically functions associated to the development, enhancement, maintenance, protection and exploitation of an intangible or DEMPE functions) that could lead to attainment of intangibles that could later be used by the multinational group – and for which the Mexican taxpayer would not demand a payment.

It was contextualized that probably, and in attention to the activities carried out by Mexican subsidiaries, a large percentage of these intangibles are of a commercial nature, and consequently (including for any kind of intangible) the taxpayer should immediately consider the recommendations made by the OECD in BEPS action 8, in particular those concerning the eventual configuration of economic property and intangible assets by some of the taxpayers, and the effect that this situation would have on cases where there were royalty payments were made for similar transactions with domestic or foreign related parties.

Another topic discussed regarded application of transfer pricing methods in this context. Given the possibility that taxpayers carry out DEMPE functions resulting in the creation of intangibles, it is evident that the use of transfer pricing methods assessing profitability (resale price method, cost-plus method, and transactional net margin method, set forth in the Art. 180, fractions II, III y VI of the LISR) cannot be applied due to the lack of comparability among the activities carried out by the taxpayer (that has generated unique and valuable contribution materialized in an intangible) and independent third parties that do not carry out these functions.

Therefore, it would be necessary to evaluate the use of profit split methods, specifically the residual profit split method (LISR 180-V), as a valid alternative for the arm’s length analysis in these type of transactions, with the implications that might arise from the application of this approach on taxable income.

Conclusions

Without a doubt, the transfer pricing regime is at a critical moment in Mexico and the world. The modifications to Mexico’s transfer pricing regime, as a result from the recommendations of the OECD in their BEPS action plan, as well as those arisen from other actors like the UN, the World Bank, and the International Monetary Fund, will undoubtedly lead to significant controversy among the tax authorities and taxpayers around the world.

Many of the considerations addressed in the forum at the UP, due to their technical nature and their relative novelty, require a systematic and institutionalized approach that will allow for the preparation of a regulatory framework adequate for this regime.

The Commission on Transfer Pricing of the National Federation of Economists continue to work in the analysis and development of controversial aspects of the SAT’s frequently asked questions and non-binding criteria, and the tax authorities have been keen to these developments. Without a doubt, this has been a step in the right direction for the creation of this very important regime.

The contributions of Mr. David Barrón, Transfer Pricing Partner in LawBiz Consulting Group, and the members of the Commission on Transfer Pricing of the National Federation of Economists in the elaboration of this summary are greatly appreciated.

A version of this article (in Spanish) was previously published in IDC Online.