Mexico: Tax authorities’ audit strategy

Luis Carbajo, Ulises Castilla and Juan Valles Baker & McKenzie

Although a new tax reform is expected to be introduced in the following months to increase Mexico's tax revenue, the tendency of the Mexican tax authorities is to conduct more tax audits than in previous years. This will result in tax assessments driving most of the upcoming tax litigation in Mexico. Tax litigation has become more relevant for today's companies and organisations, which operate in a highly competitive marketplace. Deals are bigger and the challenges are more overwhelming, and tax litigation is necessary to either challenge a tax assessment on a complex matter, or to file an action before a court of law to seek a tax saving or a tax refund.

The main sectors or industries being targeted by the Mexican tax authorities include the pharmaceutical, automotive, hospitality, telecommunications, maquiladoras, energy, and oil and gas sectors. With respect to the topics being audited, it is possible to highlight the following:

• Base erosion and profit shifting structures;

• Business restructurings;

• Royalty payments;

• Migration of intangibles;

• Intercompany services and pro-rata expenses;

• Thin capitalisation on inter-company loans;

• Permanent establishment;

• General deductions;

• Withholding tax;

• Revenue on passive income activities such as interest or lease payments;

• Extraordinary expenses;

• Exchange rate gains or losses;

• Transfer pricing methodology;

• Cash reimbursements, remittances and dividend payments;

• Formalities of tax invoices; and

• VAT on importation and exportation of services (including for commissionaire and intermediary services), and on transactions between non-residents.

In addition to the above, although there is no legal provision identifying what qualifies as an event that may be questioned by the tax authority, based on past experience, it is reasonable to conclude that an audit on the above topics may be triggered as a result of the following:

• Sudden reduction of taxable income;

• Unusual or sudden increase of tax refund requests by the same taxpayer;

• Audited financial reports with negative opinions from the registered accountant;

• Taxpayer with important income without audited financial reports;

• Significant payments to foreign entities; and

• Cash remittances.

Considering the above, audits are originated or based in most of the cases on statistics generated by the tax authority and whenever a taxpayer falls outside its existing range of taxation the likelihood of a tax audit is increased.

The Mexican tax authority is forming a programme to aggressively challenge Mexican manufacturers who relocated their headquarters overseas to shift profits out of Mexico.

According to information publicly disclosed by a high-ranked official of the Mexican tax authority, the government has identified 270 multinational corporations which were allegedly doing business in Mexico before they restructured in a way designed to "artificially move their headquarters – and profits – to other countries", including Europe.

The Mexican tax authority has a growing concern about the loss of revenue that results from tax planning and structures intended to erode their taxable base or shift their profits to other jurisdictions with a lower or more favourable tax regime. Therefore, the Mexican government, through its new audit programme, is attempting to target those companies that had substantial operations in Mexico with business activities from the beginning to the end, and which were restructured to shift their activities and profits to other jurisdictions.

Although the new programme is in the preliminary stages, it is expected that it will be ready in the next few months. Therefore, it is important for those companies that undergo a business restructuring to review their business model, their business reasons for the restructuring, and to attempt to identify any possible issues that the Mexican tax authority would be likely to contest. Consequently, the scope of any possible tax litigation will be narrowed, or the company will be better prepared to defend against a possible tax assessment.

In addition to the above, in 2013, the General Administration for Large Taxpayers will undertake an audit programme with all companies paying trademark royalties in addition to incurring advertising expenses with respect to the same trademark.

The targets of the programme are Mexican companies that have engaged in trademark migration, placing them in other jurisdictions, such as Switzerland, whereby the trademark owner was a Swiss company belonging to the same group. In such cases, the Mexican company that used the trademark would pay royalties to the owner of the intangible. However, the Mexican tax authority has found that in addition to paying royalties, the Mexican company was also making significant deductions of advertising expenses, thereby generating a dual deduction for the use of the same trademark, in the authorities' view.

In this regard, the audits are intended to determine whether the royalty rates paid are at arm's-length, and whether these rates fall within the range that would be used by unrelated parties in comparable transactions, considering that the advertising expenses are being claimed by a company that does not own the trademark.

The international double tax agreements signed by Mexico contain a non-discrimination clause, pursuant to the OECD model. However, there are international transactions that are given discriminatory treatment under Mexican law to the detriment of foreigners. For example, the Mexican Income Tax Law provides for the disallowance of a deduction of pro-rata expenses when made by a Mexican company to a foreign company.

The Mexican Supreme Court is discussing a case where it will determine whether or not there is discriminatory treatment against a foreigner in Mexico, which represents a violation of Mexico's international double tax agreements. This represents a new trend in how cases are argued before the Mexican courts. Each particular case should be examined to determine whether or not there is a violation of the non-discrimination principle.

Considering the above, and the possible implications of a tax assessment, it is particularly important that taxpayers have all supporting elements (accounting) required by the Mexican tax authorities readily available throughout their audits.

From time to time, it is possible that the supporting elements of a given transaction are held by other authorities, whether domestic or foreign, such as the certificate of tax residence of the recipient of a royalty or interest payment. Therefore, in such event, it is advisable to follow the necessary requirements to ensure compliance with all formalities established by Mexican law for such purpose and to anticipate a possible official request from a tax auditor.

The above is especially relevant if we consider that the Mexican Supreme Court issued a recent precedent indicating that Mexican courts are not bound to accept and evaluate in litigation the information and documentation previously required by the tax authority and not supplied by the taxpayer during an audit. The reasoning of the Mexican Supreme Court is that a taxpayer has the opportunity to disprove or clarify observations during the audit stage, that is, before a tax deficiency is assessed, and that litigation should not serve to give the taxpayer a new opportunity for the same purpose.

The position taken by the Supreme Court has been replicated by the lower courts, such as the Federal Court of Tax and Administrative Justice (Tax Court) and the circuit courts, in the sense that the right to offer evidence and information (constitutional right to a hearing) must be exercised before the tax authority, provided that such evidence and information are required by the tax auditor.

Following the global trend, Article 1 of the Mexican Constitution was amended in June 2011 to include the following text: "All persons shall enjoy the human rights recognised in this Constitution and in international treaties." This amendment includes the obligation of all authorities to interpret the legal provisions as they most favour citizens.

The most important precedent to this new human rights obligation for authorities is found in the ruling entered by the Mexican Supreme Court in late 2011. This ruling gave rise to various theses, all of which stress the obligation of the authorities ex officio to interpret the laws and international treaties as they most favour citizens, even setting a law aside with respect to a citizen's human rights.

Hand in hand with this precedent, the Federal Tax Court has adopted the pro hominem principle, issuing various rulings that set ex-officio precedents in favour of citizens.

This new trend in the courts opens up the possibility to argue from the standpoint of taxpayers' human rights, regardless of whether they are individuals or entities.