Over the years, governments have made important advances to implement policies that can deter and counter tax-evasion practices that have historically resulted in huge revenue loss. Although recent attention has been mainly focused on the OECD’s BEPS Action Plans, there are other earlier policies enacted by governments across the globe to tackle tax evasion, such as thin capitalisation rules to restrict the deduction of over-leveraged multinational groups.
Thin capitalisation rule in Mexico
As part of a recommendation issued by the OECD, in 2004 Congress enacted a thin capitalisation rule, which has prevented Mexican-resident entities from deducting any interest paid to foreign-resident related parties, if such interest are derived from debt exceeding a 3:1 debt-to-equity ratio.
Acknowledging that certain industries required a much higher debt ratio to operate in Mexico and in order to encourage economic activity, in December 2006 Congress amended the thin capitalisation restriction rule to include an exception for all interest arising from debt destined to finance infrastructure linked to ‘strategic industries’ which, at the time, included the hydrocarbons, petrochemistry, mining of radioactive minerals and electricity industries.
For the private sector within the electricity industry (which at the time had a limited participation as private parties were only allowed to produce electricity under self-supply, cogeneration, and small production schemes), this amendment allowed them to obtain debt with foreign-resident related parties exceeding a 3:1 debt-to-equity ratio and deduct all interest paid, as long as the debt was destined to finance infrastructure linked to the production of electricity.
However, as a result of the 2013 constitutional energy reform that, among other things, increased the participation of private entities within the electricity industry, electricity production ceased to be considered as a ‘strategic industry’ inadvertently stripping private entities of the exception regime to thin capitalisation rules.
As a result of this unintended modification to the scope of the thin capitalisation rule exception, the energy industry lobbied in Congress to include a specific exception applicable to debts acquired to finance infrastructure linked to electricity production, amendment that was approved by Congress and entered into force on January 1 2016.
In addition, as part of this amendment, Congress granted taxpayers an uncommon benefit, establishing that while this new exception to thin capitalisation limitations had entered into force in 2016, taxpayers within the energy industry would be able to retroactively apply this benefit from 2014.
After this amendment was passed, Mexican taxpayers acquiring debt from foreign-resident related parties to finance infrastructure linked to electricity production were able to legally bypass thin capitalisation disallowance rules and deduct all interest paid, regardless of the fact that such interest derived from debt exceeding the 3:1 debt-to-equity threshold applicable to other Mexican taxpayers.
Unlike other exceptions to thin capitalisation rules (such as that applicable to financial institutions just for being financial institutions), the exception applicable to infrastructure linked to energy production, as enacted by Congress, took into consideration an objective analysis, focusing on the purpose that motivated the acquisition of debt, regardless of the specific characteristics of any given taxpayer benefitting from this special rule.
Practical issues
It is important to mention that the scope of this new exception to thin capitalisation rules was not absent of criticism or uncertainty, as there was no regulation that gave clarity regarding what should be understood as infrastructure ‘linked to’ electricity production.
This broad concept eventually encouraged taxpayers to take different interpretations of the scope of the exception to thin capitalisation rules, applying this exception not only to debt acquired to finance infrastructure directly destined to energy production, such as power plants or farms, but also to auxiliary infrastructure indirectly linked to energy production, such as pipelines or distribution grids, a position that has been questioned by tax authorities.
As a result of the tax authorities’ position, Congress once again amended thin capitalisation rules, restricting their scope exclusively to entities holding a permit to produce electricity in Mexico.
As a consequence of this modification, which entered into force on January 1 2022, taxpayers who had infrastructure indirectly linked to the production of electricity but did not hold a permit for such purposes and thus, had been able to deduct all interest paid to foreign-resident related parties, found themselves in a position where they would no longer be able to continue to deduct such interest as a result of thin capitalisation rules.
This change in policy will force Mexican entities that rely in foreign debt to finance energy projects in Mexico, and that do not hold an energy production permit, to reassess the structuring and viability of their projects in Mexico as a result of the disallowance of the deduction of interest by thin capitalisation limitations.
In addition, in recent months we have seen tax authorities audit taxpayers who had benefitted from the thin capitalisation exception applicable to debt acquired to finance infrastructure related to energy production, where authorities have argued that even prior to the 2022 amendment to thin capitalisation rules, the exception to infrastructure linked to energy production activities was only applicable to taxpayers with a permit to produce electricity in Mexico.
As a result of this recent approach taken by tax authorities, taxpayers should prepare a defence file to support that the interest paid to a non-Mexican related party derived from debt invested in infrastructure linked and necessary for energy production are in fact deductible, as it may be the case that they will have to defend their position in court following an unfavourable tax audit.
