International worldwide transactions face a weakness in Mexico as a result of an old and outdated provision which disallows, for income tax purposes, the deduction of payments made abroad on a prorated basis with other parties that are not subject to Mexican income tax, such as foreign residents with no permanent establishment in Mexico.
The rationale for such prohibition in 1959 was that the Mexican tax authorities did not have the legal means to verify whether such expenses were necessary or even actually made by a foreign resident.
At first glance it might seem that the economic burden of this provision is rather limited, but in practice it does represent an important downside for the Mexican side of worldwide transactions.
This is so because it is customary that the worldwide negotiation and implementation of the transactions are agreed by the parent companies and the cost of the whole transaction is distributed between the subsidiaries of each country on a cost-sharing basis.
Naturally, in a multiple-jurisdiction transaction it can be problematic if the structure of the arrangement is changed due to the cost associated with one subsidiary, unless it is significant to the whole transaction. Normally the cost associated with this provision is accepted as part of undertaking the whole transaction, but clearly, this prohibition does represent an additional economic burden to multinational transactions in Mexico.
Since this provision was first conceived of, many things have changed. New technologies and new legal instruments allow tax authorities to review cross-border transactions, such as the double tax treaties, agreements for automatic exchange of information and more recently the FATCA agreements entered into with the United States, which were unthinkable 50 years ago.
In addition, the means of communication are now more efficient than they used to be in the past, so the information the tax authorities need to verify the existence of a transaction is available without much effort as it is now a trend to exchange such information on an automatic basis.
Further, cost-sharing agreements, which allow multinational groups to share cost between their different subsidiaries, are widely used and accepted throughout the world. Even the Organisation for Economic Cooperation and Development (OECD) has accepted the existence of this kind of agreement, as they are specifically dealt with in chapter VIII of its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which recognises the existence of multinational corporations and their corporate strength and resources to expand their operations throughout the world.
This obsolete provision has been widely discussed by taxpayers, yet the Mexican prohibition remains with all the intricacies and externalities that it entails for taxpayers without taking into consideration that the basic premises for such a denial have changed as the world has evolved.
A few years ago a multinational corporation with subsidiaries around the world, including in Mexico, entered into a global transaction for the acquisition of a division of a third party. The transaction required the participation of all its subsidiaries around the world and accordingly, the members of this group executed an agreement to share the costs associated with this transaction.
The Mexican subsidiary of this group was a party to such agreement and it had to support a part of the cost of the burden of the transaction and naturally intended to deduct the corresponding expense. However, the Mexican subsidiary was questioned by the tax authorities and rejected the deduction incurred by the Mexican subsidiary according to the agreement, under the relevant provisions of the Mexican Income Tax Law.
The Mexican subsidiary, represented by the tax practice group of Basham, challenged on constitutional grounds the provision that disallows the deduction of payments made pursuant to cost sharing agreements.
The main defence arguments were: (i) inequality, as the deduction of expenses associated with cost-sharing agreements is allowed to foreign residents with a permanent establishment in Mexico, while Mexican residents cannot claim such deduction; (ii) disproportionality, as the rejection of such deduction makes taxpayers pay income tax on a basis inconsistent with their true economic capacity; (iii) lack of legal certainty as the relevant provision does not clearly establish what a cost-sharing agreement is; and (iv) discrimination under the applicable tax treaty, on the grounds that if a Mexican entity were the global holding company and it entered into a similar cost-sharing agreement for expenses made in Mexico, indeed it would be allowed to deduct the cost-sharing expenses of its subsidiaries, even if said entities were located on foreign countries, while payments made by a Mexican subsidiary to its foreign holding company under a cost-sharing agreement cannot be deducted. It was also argued that the provision was outdated because it is now possible to audit expenses incurred in cross-border transactions, which was not possible when the provision was first enacted.
After several years of litigation before the Tax Court, a circuit court and finally the Mexican Supreme Court of Justice, the latter recently ruled in favour of the Mexican subsidiary. Surprisingly they did not rule on all of the defence arguments claimed by the taxpayer in this case, in light of the fact that this ruling was centred on the nature of the deduction and not on the other constitutional arguments asserted by the plaintiff. Accordingly, it decided that the taxpayer may now claim the deduction of such payments to the extent that certain requirements are met, namely: (i) the relevant expense must be strictly necessary for the taxpayer's activity in order to earn items of income; (ii) a reasonable relationship must exist between the expenses and the expected benefit; (iii) full compliance with the arm's-length standard; (iv) complete documentation concerning the relevant transaction; and (v) complete documentation evidencing that the allocation of costs was made on an objective tax and accounting basis, and the business reasons for entering such agreement.
Though this decision does not constitute a binding precedent, according to the Mexican precedent system, since the Supreme Court ultimately solved the case, such ruling will probably be taken into consideration when solving other similar cases. In other words, this ruling certainly opens the way so that other multinational groups in similar situations may challenge the prohibition to deduct expenses derived from cost-sharing agreements.
Furthermore this precedent is so important and valuable that even the tax authorities published on their webpage a statement declaring that it would allow the deduction of expenses from cost-sharing agreements, provided that certain requirements are met, which are basically those set forth by the Supreme Court of Justice in its decision.
Such publication is not legally binding, however it does reflect a shift in the tax authority's perspective on this matter and, again, it opens the door for other taxpayers to consider this precedent if they find themselves in a similar situation or dispute.
In sum, the deduction of expenses associated with cost-sharing agreements is now available, which is certainly a breakthrough in a tradition of more than 55 years.
Nevertheless, such deduction is not allowed on absolute terms as there are requirements to be met, which may be subject to administrative or even judicial scrutiny. Therefore, there is still a lot to explore on this matter, particularly on the tests set out by the Supreme Court, so that an expense derived from a cost-sharing agreement may actually be deducted by developing clear and fair rules so that taxpayers may actually achieve the deduction.
For example, the Supreme Court has established that there must be a relationship between the expenses incurred and the expected benefit, but how could taxpayers accurately measure that benefit? Further, what if that benefit is not materialised after all or is not materialised with the expected magnitude? Would that situation render the expense non-deductible altogether?
There is not always a direct relationship between expenses and the expected benefits. For example, in cases where several parties make contributions to develop a patent, it might be relatively easy to demonstrate the revenues that such patent raises for each party concerned once it is fully developed, but what if contributions are made to develop guidelines for human resources to be used throughout the organisation or to solve some other management issues; or, as discussed in the IRS vs. GlaxoSmithKline Group case settled back in 2006, is the research and development activity more valuable than the marketing activities or is it the other way around? In all of these cases, how could the benefit be effectively measured? What happens if no income is earned directly therefrom? What documentation may be used as evidence?
Certainly, these and other issues will have to be dealt with in the near future, but in any event this ruling is clearing the way to cost-sharing agreements.
Let us hope that in the near future the Mexican Income Tax Law is finally modified to correct this deficiency and shed light on all the issues that are still unresolved with regard to cost-sharing agreements.
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Alejandro Barrera Basham Ringe y Correa |
