Cross-Border Leasing
BY JAIME GONZALEZ-BENDIKSEN
(BAKER & MCKENZIE)
Cross-border or international leasing of industrial machinery and equipment by nonresidents presents an array of important Mexican tax issues. This article is intended to discuss these issues in general form, in a scenario where the nonresident lessor has no permanent establishment in Mexico. In carrying on the discussion we will distinguish between operating leases and financial leases.
Operating Leases
Operating or pure leases are those transactions where one party, called the lessor, grants to the other party, called the lessee, in consideration for payment of a rent, the right to temporarily use a given property, with the obligation of returning the property to the lessor upon termination of the lease. We will deal with income tax, assets tax and value added tax issues relating to these leases.
Income Tax
Mexican domestic law taxes nonresidents on Mexican-source income. Rents paid to non-residents with respect to movable property used in Mexico and destined to commercial, industrial, agricultural, cattle bidding or fishing activities is defined as being from Mexican sources. The law sets forth a rebuttable presumption to the effect that the property in question is destined to such activities and that it is used in Mexico when the lessee is a resident of Mexico or a nonresident with a permanent establishment in Mexico. Rents from other movable property are defined as being from Mexican sources and thus also subject to Mexican taxation when physical delivery of the property takes place in Mexico. The domestic withholding rate for rents is 21 percent of the gross rent.
As an exception, rents from the letting of containers and of aircrafts and ships duly chartered by the Mexican government for commercial exploitation, are subject to only a 5 percent withholding tax provided they are used directly by the lessee in transporting passengers or cargo. Note that Mexico¹s tax treaties typically provide relief from taxation of these rents.
The foregoing provisions, however, do not apply with respect to movable property included in the definition of royalties, which are considered to be from Mexican sources when the benefit is received in Mexico from the property for which royalties are paid or when the royalties are paid by a resident of Mexico or by a nonresident with a permanent establishment in Mexico. Domestic law defines royalties as:
³ Š payments of any kind for the use of, or the temporary right to use, any patents, certificates of invention or improvement, trademarks, trade names, copyrights of literary, artistic, or scientific work, including motion picture films and recordings for radio or television, as well as designs, models, plans, formulas or processes, industrial, commercial or scientific equipment, as well as amounts paid for the transfer of technology or for information concerning industrial, commercial or scientific experience or other similar right or property.² [Emphasis supplied.]
There is no express definition of Mexican law or court precedents on the meaning of the term ³industrial, commercial or scientific equipment.² In its grammatical sense, ³equipment² is defined as a collection of special utensils, instruments and apparatus for a given job. Based on this definition, it appears that the term ³equipment² is inclusive of both machinery and equipment. In that the machinery and equipment subject matter of this article are used in industrial activities, rents from their use should, in the writer¹s view, be taxed as royalties under domestic law. The applicable withholding tax rate is 15 percent.
Where the lessor is a resident of a treaty country, the rental payment will likewise fall within the scope of the definition of ³royalties² under Mexico¹s tax treaties, which indistinctly include the expression ³industrial, commercial or scientific equipment.² Under treaty law, royalties are generally subject to a 10 percent withholding tax rate.
Assets Tax
Nonresidents are subject to Mexican assets tax whenever they lease property to entities or individuals subject to the assets tax. The assets tax rate 1.8 percent of the value of the assets. The value of the assets is to be determined under the rules of the assets tax law and varies with respect to financial assets, fixed assets and intangibles, land, and inventory. Certain limited deductions from the base are allowable, chiefly the amount of debt with entities residing in Mexico or with permanent establishments in Mexico of nonresidents. Debts with nonresidents are not deductible for assets tax purposes.
The assets tax is, in a sense, an alternative minimum tax, representing a minimum 5.14 percent yield from the assets. This 5.14 percent yield, times the 35 percent corporate tax rate, results in the 1.8 percent assets tax rate. Taxpayers are entitled to credit the income tax paid in the tax year against the assets tax liability for the same year. Thus, no assets tax is payable where the income tax for the year is equal to or higher than the amount of assets tax. Where after crediting the income tax for the year there results an assets tax balance, the taxpayer may additionally credit any excess of income tax over assets tax during the immediately preceding three tax years. If assets tax is nonetheless payable, then the taxpayer is entitled to a refund of this tax from any excess of income tax over assets tax during the following ten years.
In the case of nonresident lessors, they are entitled to credit the income tax withheld against their assets tax liability. U.S. residents enjoying the reduced 10 percent withholding tax are entitled to credit not the reduced withholding but the 15 percent or 21 percent withholding rate that would apply under domestic law.
In order to comply with their assets tax obligations, non-resident lessors must register in Mexico for assets tax purposes and file estimated and year-end assets tax returns. This is an obligation that nonresidents are not happy with.
Lessors wishing to avoid the above effects should insert in their lease agreements a provision to the effect that the lessee undertakes to file, immediately upon execution of the lease agreement, an election before the Mexican tax administration to consider the leased assets as its own for assets tax purposes. This election and filing will have the virtue of eliminating any and all assets tax obligations of the lessor. It is important to stress the need for the actual filing, as the non-resident lessor is relieved from his tax obligations prospectively, from the time of the filing.
Value Added Tax
Value added tax is most important and is often overlooked by nonresidents.
General Treatment of Leases in Mexico
Leasing tangible property in Mexico is subject to value added tax. Where the lessor is a nonresident, the general 15 percent rate applies. The tax is payable whenever the rents are payable or paid or when the invoice for the rents is issued. Advances on account of future rents are also subject to VAT.
VAT applies on the entire rental payment as well as on any additional amount charged to the lessee, such as taxes, rights, maintenance expenses, constructions, reimbursements, ordinary or delinquent interest or liquidated damages.
Limited exemptions apply for rents from certain agricultural property.
Under the vatable leases, the non-resident lessor must comply with the following VAT formal obligations:
- register in the Federal Taxpayers Registry, exclusively for VAT purposes.
- issue Mexican invoices, which must be printed at specifically authorized printshops and in prescribed form.
- itemize the corresponding VAT in the invoices.
- carry Mexican books for VAT purposes.
- file estimated and annual VAT returns.
Non-resident lessors, however, are not required to collect the VAT from the lessee and pay it in to the tax administration. It is the Mexican resident lessee who is required to ³withhold² and pay in the applicable VAT.
In the writer¹s opinion, it makes no sense that the VAT is collected and paid in by the lessee, but yet the non-resident lessor is required to comply with formal obligations. We fail to see any reason of control, collection, convenience, credit of input VAT by the lessee or otherwise to compel non-resident lessors to comply with these useless obligations. The author has been lobbying with high officials of the tax administration for a repeal of these obligations. While progress has been made, the repeal is yet to take place.
Other Considerations
The above discussion does not exhaust the VAT treatment of cross-border leasing. There are a number of additional interesting and most important VAT issues.
Leases Considered Made in Mexico
The general discussion above, applies to transactions granting the right to temporarily use or enjoy property in Mexico (i.e. to leases made in Mexico). A lease is deemed made in Mexico when the lessor grants the right to use property that is physically delivered in Mexico. Physical delivery is a legally defined term. Our law distinguishes between physical delivery, legal delivery and virtual delivery. Physical delivery, as the name suggests, takes place when the property in question is actually and physically delivered to the other party, who takes physical possession. Legal delivery exists in those events where no physical delivery takes place but the law nonetheless considers delivery to have taken place. Virtual delivery, in turn, is present in cases such as where the recipient recognizes delivery contractually, although physical delivery has not actually taken place.
These distinctions are of utmost importance, as only leases where the first of the above-mentioned deliveries takes place, namely, physical delivery, will be considered as leases made in Mexico and thus subject to VAT as discussed above.
Importation
Typically the property under cross-border leases is delivered to the lessee outside of Mexico or, at any rate, before the property is imported into Mexico. Consequently, generally the lessee is required to import the property into Mexico, paying import duties and fees. Importations are also subject to VAT. A 15 percent rate generally applies. A reduced 10 percent rate applies when the importer is a resident of the border zone and the leased property remains in this zone. The importer is entitled to recover this input VAT, either from the output VAT collected from its customers or through refunds. Consequently, this VAT is not an additional cost to the lessee.
If, however, the lessor were required to deliver the leased property in Mexico, after importation, the lessor would have to contract for a third party to make the importation. Absent a permanent establishment in Mexico, the lessor will not be able to import the goods directly, as one of the requirements to carry on exports is to be subject to Mexican corporate income tax. The third party importer may face a problem in crediting the input VAT paid upon importation. The reason is that the rules regarding credit of input VAT appear to require that the goods imported must have been purchased by the importer and be deductible for income tax purposes.
An extremely significant provision having to do with importation and with leases is that leases made in Mexico are not subject to VAT when the leased property has been imported into Mexico and VAT has been paid upon importation.
This brings about an interesting question. If the lease with the importer is terminated or expires, and the assets are let to another entity in Mexico, does the exemption continue to apply? The first impression would be that the exemption should not apply because the VAT upon importation was paid by someone other than the second lessee. A more detailed legal analysis, however, would lead to the contrary conclusion. When setting forth the exemption, the law does not indicate who should have paid the VAT upon importation. Our law interpretation principles provide that where the law draws no distinction, no distinction can be drawn by the interpreter (e.g., the taxpayer, the tax administration, the court). Consequently, as under the scenario we are contemplating VAT would in fact have been paid upon importation, VAT should not apply on the rental payments from the second lessee. No distinction for the exemption to apply should be drawn depending on who paid the import VAT.
Non-Mexican Leases
In those events where the nonresident makes physical delivery of the leased property outside of Mexico, the transaction is treated as an importation of services. In these events, the lessee is required to self-asses the VAT corresponding to the rental payments in its estimated tax returns, but is entitled to take the credit for this input VAT in the same tax return. This results in a mere bookkeeping entry, as the input VAT is completely offset with the credit.
A challenging issue arises in those events where the leased property is delivered physically outside of Mexico and the lessee imports the property into Mexico, paying the corresponding VAT. Unlike the case of leases in Mexico (with physical delivery in Mexico) where there is an express VAT exemption on the rental payments if VAT is paid upon importation of the property into Mexico, no similar provision exist with respect to non-Mexican leases (with physical delivery outside of Mexico).
In our opinion, the same result should obtain even absent an express provision. The Constitution provides that taxes must be in proportion to the taxpayer¹s wealth and also equitable (i.e., preserving equal treatment for all taxpayers). It is the writer¹s opinion that VAT should not be triggered twice for the same economic transaction, as it would violate the proportional principle mentioned above. In the case of leases with physical delivery of the property outside of Mexico, VAT should be paid either upon physical importation of the property into Mexico or in the estimated tax return, as an importation of services, but not both. Undoubtedly VAT will have to be paid upon importation, together with customs duties and fees, as otherwise customs officials will not authorize entry of the property into the country. It thus follows that VAT should not be triggered as an importation of services. Further, allowing an exemption for leases in Mexico but not a like exemption for non-Mexican leases would be contrary to the equal rights protection provision in our Constitution. As a result of the above analysis, it is the author¹s opinion that under these circumstances no VAT should apply on the non-Mexican leases.
This being said, from a practical standpoint, given that, as indicated above, the VAT on the importation of services is not a cost but rather a bookkeeping entry where the VAT is reported and credit is taken in the exact same tax return, Mexican lessees would be well advised to self-assess and report the VAT, taking the correlative credit. This will prevent tax assessments and discussions with the tax administration, without tax cost to the lessees.
Temporary Importation
The law provides that where property imported on a temporary basis is ³used in Mexico,² the rules for leases made in Mexico (with physical delivery in Mexico) will apply. The question begs: does this mean that all leased property under temporary importation is subject to the rules of leases made in Mexico (that call for formal compliance with VAT obligations on the part of the lessor and actual payment of the VAT by the lessee), or does it mean that those rules will apply only if physical delivery of the leased property takes place in Mexico? In our opinion, the latter interpretation should prevail. First, because the way we read the law, when it refers to temporarily imported property ³used in Mexico,² it is not referring to the actual use of the property but rather following the somewhat unclear drafting of the law regarding what leases are vatable as a lease (as opposed to as an importation of services) namely, when the right is given to temporarily ³use or enjoy property in Mexico² which is defined as being when the property is delivered physically in Mexico (see Articles 1 and 21 of the Value Added Tax Law). Second, because we believe that whether or not the nonresident lessor will be required to comply with formal obligations cannot be dependent upon the way the lessee handles the importation, that is, that to the extent the lessor delivers the goods physically outside of Mexico, the lease is a non-Mexican lease, that cannot attract Mexican VAT obligations for the lessor, whether the lessee imports the goods into Mexico on a temporary or definitive basis. Hence, where delivery of goods under temporary importation takes place outside of Mexico, the lease should be considered an importation of services, discussed above, and not a lease made in Mexico.
Financial Leases
Financial leases are subject to entirely different rules, as they are, for tax purposes, treated as a sale and not a lease of the underlying assets. Financial leases are defined as the contract where one of the parties grants to the other the right to use tangible property for a mandatory term and the other party undertakes to make periodic payments of an amount totaling the purchase price of the property and the financial expenses and other accessory expenses and to elect, upon expiration of the term, (i) to purchase the property for a price lower than its acquisition cost, (ii) to extend the term of the lease for a rent lower than the amount theretofore paid, or (iii) to share with the lessor in the proceeds from the sale of the property to a third party. The financial lease agreement must set forth the value of the underlying property and the agreed upon interest rate or the mechanics to determine such rate.
Income Tax
As indicated above, non-residents are subject to taxation in Mexico on Mexican-source income (absent a permanent establishment). Mexican-source income is expressly defined, by way of limitation, in the law. Sales of movable property, whether located in Mexico or abroad, is not defined as generating Mexican-source income. Consequently, the lessor will not be subject to income tax in Mexico on the payments corresponding to the purchase price. Interest, on the other hand, is considered from Mexican sources when paid by a resident of Mexico. As a result, that part of the payments under financial leases, corresponding to interest, will be taxed in Mexico. The applicable withholding rate is 15 percent. Relief through lower rates may be available under Mexico¹s tax treaties, such as under the Mexico US tax treaty where reduced rates of 10 percent, or 4.9 percent if the lessor is a bank or insurance company, would apply.
The Mexican lessee, on the other hand, is entitled, as the deemed owner, to depreciate the property throughout its useful life, at the rate set forth in the income tax law. Upon exercising the end options, if the lessee elects to purchase the property or extend the lease, any additional amounts paid to the lessor shall increase the basis for depreciation during the remaining life of the property. If the option is elected to participate in the proceeds of the sale to a third party, there will be deductible the difference between the rents paid to the lessor throughout the life of the lease minus the deductions already taken and minus the proceeds received.
Assets Tax
As the constructive owner of the leased property, the lessee must include the asset in its basis for assets tax purposes. The lessee will not be entitled to deduct from the base the liability towards the lessor, because debts with non-resident entities are not deductible for assets tax purposes.
Lessors face no assets tax exposure under financial leases.
Value Added Tax
Sales are subject to VAT when made in Mexico. A sale is deemed made in Mexico if the property sold is in Mexico at the time it is shipped to the purchaser. Where there is no shipment, the sale is deemed made in Mexico if physical delivery of the property sold takes place in Mexico. We refer the reader to the discussion above regarding the differences between physical delivery, legal delivery and virtual delivery.
On the basis of the foregoing rules, if the property subject to the financial lease is shipped to the lessee from outside of Mexico, the transaction is not subject to VAT. The transaction is not subject to VAT either when the property is in Mexico at the time of the sale but there is no shipment of physical delivery in Mexico (such as the case where the lessee already has the property under a different title, e.g., under consignment).
Conversely, when either of the tests is present to considered the sale made in Mexico, VAT will apply. If the financial lease is an isolated transaction, the lessor will simply be required to issue a Mexican invoice itemizing the VAT and to keep it for a five-year period. If financial leases are entered into on a regular basis in Mexico, then the lessor will have to comply with all of the formal obligations mentioned above. The lessee, in turn, should generally be entitled to recover the input VAT against the output VAT collected from its customers or through refunds.
Jaime Gonz‡lez-Bendiksen is a Partner of the international law firm of Baker & McKenzie and heads the tax practice of the Juarez, Tijuana, Monterrey and Guadalajara offices. He can be reached at (011-52-16) 29-1307 or at jaime.gonzalez-bendiksen@bakernet.com
