Considering the historical context of the provision at the time it was first introduced into the MITL in 1959, it can be concluded that the introduction of that rule was aimed at preventing the deduction of expenses made to foreign related parties due to the lack of an effective control (audits) over such transactions.
At that time, there were no tax treaties or exchange of information agreements in place, so the Mexican Tax Authority (MTA) had no assurance of the reasonability of the expense made and thus of the justification of the deduction.
On March 19 2014, the Mexican Supreme Court (SCJN) issued its resolution for a Constitutional Appeal in regards to expenses allocated on a pro-rata basis to a Mexican company from its foreign related party. The SCJN has stated that such expenses may be deductible as long as the expenses meet certain requirements; from this resolution, four theses or criteria derived.
Background
Article 28, Section XVIII of the MITL provides that expenses incurred abroad and allocated on a pro-rata basis with foreign related parties are non-deductible.
However, neither the MITL nor other tax laws or provisions contain a definition of the meaning of ‘pro-rata’. Therefore, due to the lack of a legal definition of such term, the MTA has applied a broader interpretation.
A company, who had a tax assessment issued by the MTA in regards to pro-rata expenses that were disallowed, interposed a Nullity Petition. The Tax Court ruled that the disallowance of such expenses was a discriminatory act of the MTA, based on Article 24 of the OECD Model Tax Convention, because in contrast to the provision set out in the MITL, the deduction is not necessarily disallowed for pro-rata expenses made with Mexican related parties (assuming that the deductibility requirements are satisfied).
However, the case was challenged by the MTA before the competent Circuit Court where they ruled that the disallowance could not be considered as discriminatory since the deduction, in their view, is not allowed also where the expenses had been made with national related parties.
Finally, this case was brought by the taxpayer before the Supreme Court, and the SCJN upheld that pro-rata expenses made with foreign related parties may be deductible provided that the expenses and supporting documentation meet the following requirements:
- Strictly indispensable standard (that is, ordinary and necessary standard);
- Arm's-length principle (transfer pricing (TP) rules);
- Information of the related party abroad, such as: i) tax data (for example, TIN, tax address); ii) activities performed, assets used and risks assumed; iii) description of the TP methodology applied;
- Supporting documentation demonstrating the: i) activities performed; ii) contractual terms; iii) TP methodology; iv) comparable transactions and entities used in the TP study; and
- Documentation that demonstrates that the expenses were made following objective tax and accounting provisions, as well as a valid business reason.
Theses derived from the resolution
The pronouncement made by the SCJN in March 2014, gave rise to the four theses issued, which state the following:
1) In the first thesis, it is outlined that the reason why pro-rata expenses are not deductible is because pro-rata expenses were not possible to audit, since neither the exchange of information process was implemented nor did the SAT have the adequate team to track those kind of expenses.
2) The second thesis emphasises that pro-rata expenses made with parties who are not considered as income tax (IT) taxpayers, would not be deductible even when related parties who are considered as IT taxpayers had participated in the allocation transaction.
3) The third thesis states that even though there is an express prohibition for the deduction of pro-rata expenses pursuant to literal interpretation, the Court inferred that due to a systematic and progressive interpretation of Section XVIII of Article 32 (as part of the tax reform package effective from January 1 2014, references made to Section XVIII of Article 32 MITL should be understood as made to Section XVIII of Article 28), the expenses made with residents abroad, on a pro-rata basis may be deductible as long as they comply at least with the following:
o The transaction has been performed at arm’s-length.
o The Company keeps the supporting documentation of the expense made, where can be demonstrated that the expense was effectively made, the amounts incurred, that the strictly indispensable standard was met, that the expense was made following objective tax and accounting principles and real business reasons.
o That there is a reasonable relationship between the expense made and the benefit obtained.
Therefore, the provision set forth in Section XVIII of Article 32 of the MITL should not be understood as absolute and unrestricted. On the contrary, it would be necessary to analyse the corresponding agreement as well as the documentation linked to it to determine if there is a reasonable relationship between the expense made and the benefit obtained.
4) Structural deductions, which shall be understood as deductions related to the business objective of the company, allow determining adequately the real contribution capacity of the taxpayers. Therefore, the determining element for paying income tax is the contribution capacity (that takes into account the structural deductions) instead of the corporate structure of a taxpayer. Thus, pro-rata expenses may qualify as structural deductions.
Based on the foregoing, pro-rata expenses paid abroad may be deductible, as long as they comply with the requirements set forth in the domestic law and in the criteria stated in the resolution and with the theses mentioned above.
However, it is important to bear in mind that the MTA may still take a subjective position in regards to some of the concepts included in the mentioned precedents in order to disallow the deduction of pro-rata expenses, since the resolution is not conforming to ‘jurisprudence’.
By principal Tax Disputes correspondents for Mexico, Fernando Lorenzo (fernando.lorenzo@mx.pwc.com) and Laura Enriquez (laura.enriquez@mx.pwc.com), of PwC.
