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Assessing Mexico's Recent Tax Reform

(EDITOR's NOTE: Strategies recently asked Miguel A. Valdés to evaluate Mexico's 2002 tax reform. Mr. Valdés is a Tax Partner with Ernst & Young, LLP and Director of the firmÕs Latin American Business Center, located in Chicago and New York. Mr. Valdés is also a member of StrategiesÕ Advisory Board.)>

Strategies: Now that the 2002 Mexico tax reform has begun operating, have you uncovered any surprises in its administration?

Valdés: There have been a number of surprises. The first surprise, of course, was the fact that the legislation was approved, according to some people at 3 o¹clock in the morning on January 1, according to some other people, at 4 o¹clock in the morning. Whether 3 o¹clock in the morning or 4 o¹clock in the morning, there is a question as to whether the reform is even constitutional, because the Constitution in Mexico requires approval at the latest by December 31 so that it can be implemented the next day. We are still wondering if anybody is going to take this to court or not.

Strategies: As a matter of fact, in the January-February issue of our Practical Mexican Tax Strategies, Jaime González-Bendiksen of Baker & McKenzie details a number of reasons why he thinks many of these tax reform provisions are unconstitutional. For example, he asserts that many of the provisions violate the equal protection rights guarantee in the Constitution. He also notes that all the VAT amendments were introduced by the Senate, contravening the constitutional requirement to the effect that for tax matters, all laws must originate in the House of Representatives.

Valdés: I discussed this with Jaime and I agree with him 100 percent. There are a lot of constitutional problems with the legislation.

Strategies: The companies that might protest the constitutionality of the Mexican law in court, will that mean that there¹s a precedent for the Mexican Supreme Court to declare the law unconstitutional or might it be similar to Brazil where they find it unconstitutional for one party and it doesn¹t apply to the rest?

Valdés: They do it exactly as they did in Brazil, unfortunately. That¹s the way that it works. It will take more than one decision before you can really say that the law cannot be applied. Unfortunately Mexico, like Brazil, is a civil law system and consequently, you don¹t have precedent. So you have exactly the same problem as you had in Brazil.

Strategies: What other problems or surprises have you found?

Valdés: Another problem area is the luxury tax. The way that it has been implemented makes no sense. Many cheaper items are subject to the tax and many more expensive items are not.

Another problem is the change on the VAT from an accrual to a cash basis. The authorities told us that was going to be a piece of cake, and now they have had to make extensions to the provisions because it is not easy to administer. Changing the mentality that has been going on for years and years to account for your VAT on an accrual basis and changing it to a cash basis is a very large administrative job.

Strategies: With regard to the accrual vs. cash basis for the VAT, please explain what companies are doing now to address this and what should they do.

Valdés: Probably there is more written about the value added tax than on any other tax in Latin America. The majority of the legislation about value added tax in Latin America specifies that an entity has to either pay the tax over to the authorities when it issues an invoice, or when it collects the tax, whichever one comes first. Now, which one always comes first? The issuance of the invoice, of course. That¹s why this was on an accrual basis. When you issue the invoice regardless of the fact that you did not collect the money, you had an obligation to pay the government the money that related to the particular sale that you have made. You had to turn over the VAT as if you had collected it already. Now, under the new regime, you are only going to report it when you get the money from the client. Strategies: Sounds like a benefit.

Valdés: It is a benefit in the long run. But take a closer look. We are talking about years and years of people used to paying this tax over on an accrual basis‹every time an invoice is issued, the tax is paid automatically. Now, think about it from an administrative point of view. Now you are going to have to track all the sales that you made, and then watch out every time you collect money; now you are going to have to set up a different system that says when the money comes in, I¹m going to have to put aside the money from what I¹m collecting on the sale that I made for the services that I sold, and then I¹m going to have to put aside the other money that I¹m going to have to send to the government and check it and send it to the government as I am paid.

Strategies: Yet it sounds like a cash flow benefit.

Valdés: Eventually it would be a cash flow benefit because now you are only going to pay it after you collect it. But it¹s going to be an administrative nightmare. That¹s why the implementation has been postponed already. It was supposed to start on January 1 and now the authorities are saying maybe April 1. They are afraid that people are not going to have the systems in place. Remember that everything is systems now, so what you see as something that is very simple and makes sense from a cash point of view, from a systems point of view, it is a nightmare. A lot of the systems are not geared to do it this way. Most of the systems were just designed so that the moment you actually issue the invoice, you pay the VAT. The programs have to be rewritten. That¹s what I mean about such an administrative burden. However, at the end, it is going to be beneficial because you are only going to pay VAT when you collect it, which is very nice.

Strategies: Are there other areas of administrative interpretation that you expect some guidance on in the immediate months ahead?

Valdés: What we are expecting is a new reform, to be honest with you.

Expecting a New Reform Strategies: A whole new reform again?

Valdés: We are expecting a new reform to be introduced in April or in May at the latest.

Strategies: A new reform of the income tax?

Valdés: Income tax and VAT and so on. The president might try to impose VAT on food and medicines again. Last year, that was really a debacle for him. The PRI actually took him to the cleaners because of that. As one columnist I know has said, President Fox was a magnificent candidate for president. He¹s really been a lousy president because he¹s not a good politician. And they are taking him to the cleaners because the other side has 71 years of being in power and they are great politicians. He¹s not doing the things that he should be doing as a politician to get the things done in a congress in which he doesn¹t even have a majority. He has to be more of a politician when you have conditions like that and unfortunately he¹s not good at that game. Strategies: Are you finding that the tax authorities are taking a tougher position as they search for new revenues and what are the most contentious issues?

Valdés: The tax authorities absolutely have been taking some very tough positions with us in some cases when we¹ve gone to talk to them. And they say they¹ve gotten the word that if you want to go and litigate, well at least we keep the money for awhile that way. The most contentious issue right now continues to be the asset tax, and what is the taxable base for the asset tax. And I am sure that many of the provisions of the reform are going to be litigated because I think some of them are unconstitutional.

Holding Companies and Other Entities Strategies: The tax reform has new rules for holding companies and changes for other entities. Are you seeing a change in strategies for merger and acquisitions and for direct investment as the result of these changes?

Valdés: There are more specific rules now for mergers and acquisitions in order to do reorganizations tax free. Mexico is getting more and more like the U.S. The rule regarding holding companies is that while previously holding companies were great, they are garbage now. They really now very rarely work. I cannot recommend to my clients that they have a holding company in Mexico any more because you don¹t get the full benefits any longer. All you get now is that the holding company may consolidate 60 percent of its income or loss. For most of my clients, I¹m getting them out of having holding company groups in Mexico. Usually what we¹ve been doing is to have something in Europe. One of the best setups is to have a Dutch company be the parent company and have the Dutch company be owned by an ETVE, a special holding company that they have had in Spain since 1997. The ETVE was copied from the Irish and the Dutch. But it is better than the Dutch because from The Netherlands to the U.S. the dividend is subject to a 5 percent withholding tax. From Spain to the U.S. or to any other place, the dividend is zero. You¹ve got a benefit and that¹s why we¹ve been using Spain in most of our planning techniques now for a number of years.

Strategies: I understand from articles you have written that the tax reform broadened the definition of a taxable entity such that it now specifically includes an Asociación en Participación (AenP). How is this entity used and what is the significance of these changes?

Valdés: An Asociación en Participación is something that we use for planning purposes but it¹s really used mostly in Latin America for transitory projects. When you don¹t want to create an entity, what you do is have a contract, and you can create an entity by contract only. It is a fictional entity that you create for tax purposes and the authorities are going to treat it as an entity, though the entity does not exist. It only exists on the terms of the contract that you have entered it.

This is the second or third time that they have changed these rules. What the government is trying to do is to get the AenP to be a taxpayer and to pay taxes like any other entity. There used to be a lot of games in the past when AenP used to be a transparent entity and didn¹t pay taxes. But the government has been making these changes for the last two or three years and making it worse and worse for planning, so you don¹t have as many opportunities in Mexico with these entities any longer. Now we are using the planning techniques in some other countries, to be honest with you.

Strategies: But these Asociación en Participacións are not subject to the transfer pricing rules?

Valdés: Exactly. Because of the fact that these AenPs are entities that you create by contract, and the ones that are going to subject to transfer pricing have two owners. The AenP is going to pay taxes but it is not going to be subject to transfer pricing, because usually what you utilize it for is local transactions. So the authorities are just saying we are not going to hold you to transfer pricing but if you have a lot of transactions, they could actually look at the people behind the AenP and try to get to you.

Strategies: Do you have a device that you are now using instead of an AenP?

Valdés: The AenP is now only being used for commercial reasons. It is not very helpful from a tax point of view. We are now using limitados such as SRLs and CV. For example with a CV we can have variable capital. However, if we have an SA, we cannot take advantage of the U.S. check-the-box regulations. So we use the limitados, which are the SRLs and CV, to give us the flexibility that we need from a U.S. point of view.

Strategies: As you work through the new tax rules, are there any special issues that might relate to planning for cross-border royalty and technology transfers?

Valdés: For royalties, we need to use treaties. That is the best planning that we have. Using treaties, you are still going to have to pay some withholding tax but at least we can get it down to as low as 10 percent in some cases. The other thing is in the case of royalties we also might find that the client is providing some technical services, which can be provided from the U.S. Then we try to segregate the two.

Strategies: You provide technical services from the U.S., then segregate it?

Valdés: Exactly. And then you don¹t do any in Mexico because then you have a chance of charging the Mexican entity for those technical services and getting paid with no withholding tax if the services are all done in the U.S.

Strategies: What advice do you have about new income being subject to withholding tax such as factoring income and leasing income?

Valdés: Again, the authorities are expanding the definition of what interest is from the Mexican law point of view. They are trying to cover everything. We used to have a planning technique that, for example, let¹s say the Mexican enterprise is making too much money, and then what you do, is to take the receivables that they have from its customers, and you sell it to an affiliate that needs money, before they mature. And then of course you had to sell them at a discount, because that is what a bank would do. They will buy receivables at this discount from you, because if I¹m not going to get paid for a month more or something, I¹m not going to pay you what you have on the books. So then what you do, is to reduce the income in Mexico because you create a loss and then the question is, when you collect on that receivable, what do you have? Do you have a receivable for the price of what you bought it for and the difference is interest? And that¹s what Mexico is defining. They are saying that difference is interest and subject to withholding tax when you get the payment. So when you get the payment for 100 units, 5 will be interest and subject to withholding tax. Mexico is setting the trend for Latin America for sophistication of the tax laws. In most of the other countries, there isn¹t as much sophistication and as much detail as what Mexico is developing. The U.S. IRS is training the Mexican authorities and they learn here. They exchange a lot of information with the IRS.

Strategies: Do you have any planning around this issue?

Valdés: We factor it in our advice. What we can do is just try to reduce withholding taxes whenever possible. We try to use a financial institution if at all possible. The financial institution buys the receivables and when it gets the payment of interest, instead of that interest being subject to up to 35 percent withholding, now it would only be 4.9 percent. You reduce the withholding tax substantially. If not, then you try an arrangement with a treaty country and with a lot of the treaty countries, withholding is either 12, 15 percent or something like that. So you can reduce it, but not as much as you do with a financial institution.

Strategies: Are there any other impacts of the tax reform of special concern?

Valdés: The biggest disappointment was profit sharing not being deductible again and actually the probabilities of it ever being deducted will now be reduced substantially. So that was a big disappointment for me because this is really quite a problem in Mexico.

Strategies: You said that the president is going to introduce reform legislation again. What¹s the political chance of some of that being enacted?

Valdés: If the president continues to behave the way he has been, it¹s not going to be very good. For example, a lot of the people in Congress are finding out about the reforms that he¹s proposing by reading the newspapers, and the VAT proposal for medicine and food was very costly for him from a political point of view.

Strategies: We ran a piece recently on tax accounting for inflationary effects, but the inflation rate is now much lower. Is this still a big issue in terms of tax planning?

Valdés: We still worry a lot about inflation accounting because, remember, you can only deduct interest expense that you have in excess of the impact of inflation. You do not get entirely. ThatÕs why we cannot recommend to a client that they go out and borrow. For example, I have a client in Brazil, I can tell him, borrow until youÕre blue in the face because, the only thing that, if you create a loss, youÕre going to have a limitation, once that loss becomes a carryforward loss. But I have nothing else to worry about. The only thing I tell the client, is try not to make it a net operating loss carryforward, but then youÕre going to have your 30 percent limitation in the future. In Mexico, I cannot tell that to a client. I say, before you borrow, you run the numbers, take a look at your assets, take a look at your calculation, because in some cases, we have had clients that if they were to borrow, actually would have meant creating more income than getting a deduction, so you have to really be very careful with this calculation. The most dangerous places for this issue are usually Mexico and Venezuela, because of the way you do the calculations. For example, in Venezuela, it can create phantom income. In Venezuela usually youÕre talking about oil companies that are borrowing very large amounts of money, and thatÕs when they have the problem, because you have a government that is controlling the exchange rate and yet inflation is really going wild. The differences between the exchange rate changes and the inflation changes can create income in a very large way and that income is subject to current taxation in Venezuela. So you have two different issues; the impact on interest deductibility in Mexico and the impact of creation of phantom income as we refer to it in Venezuela.