The evolution of the substance-over-form doctrine in Mexican tax disputes

To understand the evolution of the substance-over-form principle, we offer a chronological analysis with a case-law approach. In this article, we will demonstrate how this principle has taken root in the resolution of disputes, and how it seems to be refreshing the traditional approach to the tax legal framework.

Within Mexico’s legal framework, as in many other Latin American countries, the principle of legality holds a constitutional rank of highest importance. For this reason, procedural formality has historically prevailed over substance.

Formal requirements, especially regarding tax matters, have been considered legal certainty mechanisms that allow authorities to verify compliance with tax obligations. In some cases, this reaches to the extent that the formality seems to merge with the substance.

In the tax controversy and disputes field, the Federal Court of Administrative Justice (FCAJ) and the Supreme Court of Justice (SCJ) have repeatedly upheld that the fulfilment of formalities set by the law is required for taxpayers to access substantive rights and benefits. This notably applies to income tax deductions and the application of creditable VAT.

The reason behind this criterion revolves around the nature and effects of deductions, which naturally result in the decrease of the taxable income and, consequently, of the payable tax. The application of creditable VAT also influences the determination of the payable tax.

Therefore, it is of utmost interest for authorities to be able to verify the grounds and merits of these concepts, which is believed to be done, at least on a superficial level, by confirming that the taxpayer complied with all formal requisites.

In 2001, the SCJ ruled that a requirement established in the Income Tax Law (ITL) which requires expenses covered through paychecks to be made using a check that contains the expression “to be credited to the beneficiary’s account” is required to admit the deductibility of the expenditure (criterion 2a. XI/2001).

With similar reasoning, in 2005, the SCJ ruled that the untimely filing of informative returns results in taxpayers losing the right to deduct loan-interests paid abroad. In this case, the late filing has the same consequence as the failure to file the declaration at all (criterion 1a. XXXV/2005).

This SCJ criterion was so important that the timely filing of the informative return as a deduction requisite was expressly introduced to the ITL and is still in force according to article 27(V, XVIII).

Further, in 2016, the FCAJ upheld that according to the Customs Law, the export return was the suitable and exclusive documental evidence to prove that merchandises imported under a temporary regime had left the country on time. Without this particular document, the authority could conclude that the merchandises remained within the country illegally (criterion VIII-J-1aS-9).

These judicial decisions were sustained on a rule-of-law approach that prioritised form over substance. This approach, with a very cold and rigid spirit, failed to consider the true purpose of the legal provisions in order to conclude whether this purpose had been infringed or not.

The constant application of this inflexible approach not only generates a depersonalised relationship between the authorities and the taxpayers but also, in several cases, translates to the creation of artificial tax bases that do not reflect an economic and financial reality.

For instance, the fact that a check fails to contain the expression “to be credited to the beneficiary’s account” is insufficient to prove that the amounts were, in fact, credited into a different account to the entity that provided the goods or services. Therefore, rigidly rejecting the deduction of the related expenses could deprive the taxpayer of proportionally contributing on the sole basis of a formal default, even when the purpose of the provision could have been substantially honoured.

Because of this context, taxpayers have had to resort to litigation, seeking to demonstrate before the courts that the tax bases determined by non-compliance with formalities are truly artificial. Clearly, this has produced an excessive judicialization of tax assessments that, in substance, hold no merit and represent high costs for both the state and taxpayers.

On this point, the over-application of formalities has not only caused discomfort to the taxpayers but also to the tax authorities who, in many cases, face obstacles to collect taxes given the constraints that the principle of legality impose.

For a long time, the line that separated form and substance was so thin that the two universes seemed to constantly collide. Fortunately, in recent years there has been an identifiable transition to a more flexible environment where the substance-over-form doctrine has a greater impact.

The beginning of this transition can be traced back to 2014. In this year, Mexico introduced domestic tax mediation as a formal alternative dispute resolution procedure through the tax ombudsman agency, PRODECON (Procuraduría de la Defensa del Contribuyente). This provides taxpayers under audit with a flexible mechanism to disagree with the tax authority’s preliminary assessments.

Through tax mediation, traditionally closed-door examinations were transported to a crystal box where disputes over facts and legal provisions are aired before an impartial third party whose main purpose is to help reach a mutually binding agreement for the case at hand.

The benefits brought by tax mediation include less judicialization of cases without merit, greater transparency between authorities and taxpayers, and an increase in tax collection. However, for the purposes of this article, the most relevant reward was the first construction of an appropriate venue in which to discuss substance over form matters.

The fact that tax mediation is not a contentious procedure by nature encourages a more flexible environment where the original purpose of tax provisions can be unravelled in order to determine whether this purpose had been met or not by the taxpayers.

With the aid of PRODECON as a mediator, the cold and rigid approach to formalities has been surpassed in many cases to reach very interesting settlements where the tax authorities have agreed to prioritise substance over form to resolve the dispute.

It is documented that a tax mediation request was filed before PRODECON regarding the rejection of deductions to a taxpayer that covered expenses using checks that did not contain the expression “to be credited to the beneficiary’s account”, as formally required by the ITL (see p. 2, criterion 2a. XI/2001) (Uribe, 2015, p. 230).

The taxpayer shared documentation including invoices, contracts, accounting records, and bank statements that proved the funds had been deposited into the service provider’s bank account, which is the objective pursued by the unfulfilled norm (avoiding the circulation of the check).

The tax authority initially upheld its determination asserting that the deductions had to be rejected because they did not comply with the formality set in the ITL. However, as a result of several meetings between the parties to analyse the evidence, the authority conceded that it was proven that more than 95% of the expenses had been deposited into the account of the service provider. Therefore, the preliminary assessment was considered without grounds and a settlement in those terms was reached.

In another tax mediation procedure that involved a Customs Law provision, the tax authority had preliminarily assessed that an aircraft imported under a temporary regime remained within the country illegally. The illegality was because the taxpayer failed to exhibit the export informative return which, by law, is the suitable document to prove the outgoing of goods (see p. 2, VIII-J-1aS-9) (Uribe, 2015, p. 257).

During the audit, the taxpayer argued that there was no export return because the aircraft left the country without being subject to customs formalities. The taxpayer provided official documents issued by US government agencies that comprehensively demonstrated that the aircraft left the country complying with the time limit established by the temporary import regime.

Finally, the tax authority conceded that the evidence presented was sufficient to prove the aircraft was exported on time, and the parties entered into an agreement on those terms.

These examples show the increasing use of the substance-over-form principle to resolve tax disputes and even prevent litigation. This stablished an appropriate forum to analyze on case-by-case basis whether non-compliance with legal formalities justified sanctioning the taxpayer with the loss of rights and benefits, particularly when the sanction entailed a tax liability assessment on an artificial basis.

At this point, even within the jurisdictional field of the FCAJ, some Chambers started to prioritise the substantive resolution of disputes.

In 2018, one Chamber issued a ruling on a case regarding a tax liability of more than MXN 11.6 million ($550,000) allocated to a non-profit sporting club for having received advance payments of maintenance fees and failing to report said fees in the year in which they were received. The advance payments were reported in the following year, the same year in which they were used by the non-profit (Case 290/11-17-01-5).

For this case, the tax authority referred to an ITL provision that allowed it to assume that the late-reported fees constituted accruable income that had been distributed among the members of the sporting club, which generated the tax liability.

However, the Chamber ruled that as the advance fee payments were reported and applied the year after they were received, this was at most a formal default, but was not sufficient to support the determined tax liability. On that basis, the Chamber annulled the determination of the tax authority.

This case exemplifies how the substance-over-form principle had been expanding, at least practically, from tax mediation all the way to jurisdictional rulings. Nevertheless, it is important to consider that, in this context, there was no regulation in force that established a clear set of rules for the application of the principle. This meant its implementation was still at the discretion of the involved parties.

In 2017, a greater step was taken towards the evolution and practical application of the substance-over-form principle. A new modality of the administrative annulment trial before the FCAJ was introduced, which now allows taxpayers to challenge tax liability assessments exclusively arguing substance matters. In parallel, a specialised Chamber to conduct these trials was established inside the FCAJ.

Aside from other interesting adaptations (such as oral hearings, the waiver of warranty for trial, an expedited procedure) for this special type of annulment trial, an additional provision regarding the grounds for nullity of a tax liability assessment was created.

This provision states that the court can annul a challenged assessment if it determines that the effects attributed by the tax authority to the non-compliance of formal requirements are excessive or disproportionate, given that the taxable events did not occur.

From this point forward, taxpayers were granted access to an adversarial procedure in which the court not only conducts litigation oriented by the substance-over-form principle, but, furthermore, is compelled to rule on the basis of said principle.

This represents significant progress from the achievements previously reached through tax mediation, given that in this procedure, the application of the principle is merely an option and, more importantly, the agreements entered into by tax authorities and individuals cannot constitute legal precedents.

In recent years, the results of this substance-over-form annulment trial have been significant, especially when it comes to the construction of criteria issued by the specialised Chamber of the FCAJ.

For example, in 2018, an FCAJ ruling was issued on a matter in which the auditing authority had determined a tax liability of over MXN 63.5 million ($3.2 million) to a non-profit organisation. This was on the grounds that the non-profit filed an informative return of yearly revenue and expenses in an untimely manner (Case 61-18-ERF-01-1).

Based on the formal default, the tax authority applied an ITL provision to assume that the late-reported revenue had been distributed among the members of the non-profit organisation, generating a corresponding tax liability.

In the ruling, the specialised Chamber determined that even when the filing of the informative return was untimely, the tax authority had accurate knowledge of the income perceived by the organisation, which is the purpose behind the filing of said declarations.

The Chamber also considered that the tax authority rigidly undermined the information presented and limited itself to assess the liability exclusively on the grounds of the formal default, even when, in reality, the organisation did not fail to report income and there was no tax omission.

Moreover, the ruling reasoned that the failure to report income could not be equated to reporting the income late, because that would imply an oversimplification harmful to the organisation’s rights (See p. 2, criterion 1a. XXXV/2005).

On those grounds, the FCAJ annulled the tax liability assessment, given that the consequences attributed by the authority to the formal default were considered disproportionate (criterion VIII-CASE-REF-29).

In another relevant case solved in 2019, the specialised Chamber ruled on whether amounts received through inheritance, which are tax-exempt by law, became accruable income if the taxpayer failed to promptly report such income within the time limit set by the ITL (case 77-18-ERF-01-8).

On this matter, the auditing authority had issued a tax liability assessment in which it concluded that more than MXN 22 million ($1.1 million) received by a taxpayer constituted accruable income, given that the taxpayer reported the inheritance beyond the ITL timeframe.

The Chamber analysed the explanatory memorandum of the ITL and determined that the legislators’ original purpose has always been to exempt any income perceived by inheritance. For that reason, the nature of said income could not be altered by a formal default, as it was the untimely report of the inheritance made by the taxpayer.

In addition, the ruling considered that the auditing authority had factual knowledge that the disputed amounts corresponded to an inheritance. On those grounds, the Court annulled the tax liability assessment and created the legal precedent VIII-CASE-REF-32 that summarises the above.

Lastly, in 2020, the specialised Chamber published criterion VIII-CASE-REF-12 that rules on the above-mentioned formality set by the ITL which requires checks to contain the expression “to be credited to the beneficiary’s account”, in order for the expenses to be deductible.

In this criterion, the Chamber recognises that to overcome the sanctions that derive from the default of the formality, the taxpayer holds the burden of proof and has to demonstrate that the amounts were effectively deposited into the services or goods provider’s account. It is notable that this reasoning emulates, now on a jurisdictional level, the rhetoric previously employed within a CA before PRODECON.

In summary, the remarkable jurisdictional activity of the specialised Chamber has produced very interesting criteria that strongly uphold the substance-over-form principle within the resolution of tax disputes.

Mexico has made significant progress in the practical application of the substance-over-form principle, transitioning from a rigid rule-of-law environment to a more reality-based one. This can be attributed to the implementation of tools such as the mediation procedure before PRODECON and the substance-over-form trial before the specialised Court of the FCAJ.

It is important to state that this transition should not be interpreted as a crusade against the principle of legality, which undisputedly constitutes a cornerstone of the legal framework. Rather, it should be seen as an interesting venture to honour the true purpose of tax legal provisions and to contribute to a fairer taxing system with a more reasonable resolution of disputes.

It is exciting to witness the evolution of the substance-over-form doctrine in Mexico and the outcomes it will surely continue to provide in the coming years.

The authors are especially grateful to Aaron Schabes Cano, tax-associate, for his invaluable help in achieving the definitive version of this article.