As part of the 2022 strategic revenue programme (a document that the Mexican tax authorities have been publishing since 2020, with a description of the main auditing and revenue strategies to be pursued during a given fiscal year), the Mexican tax authorities highlighted their focus on compliance with the deductibility requirements for cross-border service payments. In the context of Mexico’s position on countering BEPS, this strategy has been prominent in recent audits.
Taxpayers often face difficulties in undermining these assessments, mainly due to the lack of a proper defence file to support the “indispensability” and “materiality” related to the cross-border service in question, both of which are substance requirements established under Mexican tax laws and case law that taxpayers must meet to deduct an expense for income tax purposes.
There are other formal requirements that taxpayers must meet to deduct these types of expenses, but this article focuses on the substance requirements that have evolved through judicial precedents.
Indispensability
Article 27-I of the Mexican Income Tax Law (MITL) establishes that expenses must be strictly necessary or indispensable to carry out the taxpayer’s business activities.
The Supreme Court of Justice has established through mandatory precedents that an expense should generally be considered as strictly necessary – and thus deductible – if it is incurred for producing income, or if it appears to be logically incurred to increase or maintain income flows. The Supreme Court recognised, however, that there are scenarios in which such expenses may never translate into income, and that although this should not be sufficient to disallow a deduction, the intention of creating income must at least exist and be supported by evidence.
Following this standard, an expense that is excessive or disproportional to the economic benefit that a service may produce could be questioned or disallowed, based on the fact that the expense would not necessarily be directed at producing profits for the service recipient.
Other court cases have also established that expenses are considered indispensable if they are directly related to the activities that, from a legal perspective, a company is incorporated to pursue, (such activities are typically established under the company’s by-laws or corporate charter).
In the context of cross-border services, providing evidence supporting that the expense is directly related to producing income may be more or less challenging depending on the type of service that the Mexican taxpayer receives.
Typically, when administrative services are rendered by foreign related parties outside Mexico (for example, accounting, finance, IT, and human resources), it is difficult for tax authorities to argue that the services are unnecessary to produce income. Thus, tax authorities will scrutinise the values at which the service is charged. In such cases, taxpayers should maintain, among others, detailed cost calculations and transfer pricing studies to support that the considerations were paid at arm’s length, and evidence to support that there was no duplicity in the activities that were conducted by local personnel and the foreign service provider (when applicable).
For other services obtained from foreign related or third parties (including administrative), tax authorities may deny the deductibility of the expense if the service is unrelated to the business purpose of the recipient (as legally described in its charter), or if there is no proof that the service will assist the company in obtaining an economic benefit. Therefore, maintaining technical documentation that describes the nature of the service and that evidences its connection with the business purpose of the Mexican taxpayer is key.
Materiality
Taxpayers must demonstrate the materiality of business transactions if they are to recognise any tax effects derived from an invoice (i.e., use it as support to deduct a payment), by demonstrating that the services or goods they have paid for correspond to the services or goods they received.
Judicial precedents have repeatedly stated that the materiality or existence of a service is not evidenced by simply maintaining a service agreement, an invoice that complies with all the applicable legal formalities, and a bank statement. Although such documents are helpful, Mexican courts have established that a deduction should only be allowed if taxpayers maintain evidence to support the fact that the service existed.
The specialised substance-over-form chamber of the Federal Administrative Court has listed a series of documents (non-exhaustive) that are useful in supporting the economic substance and materiality of services received, including the following:
Documentation to support the conditions under which the service was offered.
Documented negotiations held before the services were retained.
Evidence to support that the transaction was formalised from a legal perspective.
Evidence to support that the obligations derived from the legal arrangement formalised among the parties were effectively pursued after their execution.
Deliverables generated as a consequence of the activities covered under the service agreement. This is particularly relevant and it includes any evidence to support the effective performance of the services.
For administrative services, timesheets on which the contractor’s personnel describes the activities performed, the time incurred in performing such activities, and the rates applicable for the services rendered by each employee.
Withholding obligations
In terms of the MITL, a payment is not deductible if withholding obligations are not complied with. With regard to cross-border managerial or administrative services, for instance, no withholding tax should apply in Mexico where the services are fully rendered from abroad. However, if the service is even partially rendered in Mexico, a 25% withholding tax should apply.
Since it is the taxpayer that must prove that services were fully rendered from abroad, documentation related to the location of the personnel while rendering the services is of the utmost importance.
As a general rule, Mexican double tax conventions restrict Mexico’s taxing rights in connection to these types of services if the foreign contractor has no permanent establishment in Mexico, as they are treated as business profits. However, careful analysis must be made in order to assess if the services fall under the local and treaty definition of royalties, in which case the Mexican taxpayer would be required to withhold at a rate that ranges from 1% to 25% (pursuant to domestic law), with the latter reduced to 10% under most Mexican treaties.
In an environment where tax authorities have been enforcing BEPS-related policies with increasingly heavy scrutiny as regards companies that retain services from foreign residents – whether related or independent – keeping and building a strong defence file to support their indispensability and materiality is fundamental to avoid deductibility issues.
