As with most members of the OECD, Mexico has tax provisions for taxpayers regarding transfer pricing. These are applicable to taxpayers that carry out related-party transactions, according to Title II (companies) of the Mexican Income Tax Law (MITL). The main objective of these provisions is to determine if the conditions of the related-party transactions are the same as those that third parties would have considered in comparable circumstances; that is, the related-party transaction should comply with the arm’s-length principle.
The Mexican tax authority publishes on a yearly basis an Audit Master Plan, which broadly outlines the actions that the Mexican tax authority will focus on regarding collection, taxation, and taxpayer support. The Audit Master Plan for 2024 includes concepts and actions that could affect related-party transactions and the companies involved.
Over the past few years, the Mexican tax authority has had a particular interest in auditing transfer pricing transactions, and, as such, these audits have become especially relevant for Mexican taxpayers. The current tax landscape is focused mostly on taxpayers with activities within the following industries, among others: steel, food, automotive, beverage and tobacco, mining, pharmaceutical, manufacturing, real estate, financing, technology, oil, and tourism.
There are also concepts and behaviours that are reviewed by the Mexican tax authority, including cross-border transactions with related parties, corporate restructuring, stockholders’ equity valuations, intangible valuations, analysis of recurring losses, and financing transactions.
Based on the aforementioned, it is important for Mexican taxpayers to consider the current audit trends and practices by the Mexican tax authority in order to minimise a possible transfer pricing audit, or to react accordingly through the audit process.
The main trends and practices followed by the Mexican tax authority from a transfer pricing perspective may include the following:
Compliance with the arm’s-length principle;
Questioning if the transaction is strictly indispensable;
The transaction’s materiality; and
Validating the effective provision of the transaction.
Compliance with the arm’s-length principle
As part of a transfer pricing audit, there are discussions regarding the fulfilment of the obligations set forth in the MITL for taxpayers that perform related-party transactions. In this regard, the MITL establishes that taxpayers must obtain and maintain supporting documentation to prove that the amount of income or deductions in any related-party transaction complies with the arm’s-length principle.
This supporting documentation should contain:
The tax identification number of each related party with which the taxpayer performed transactions;
The functions performed, assets used, and risks assumed by each entity in every related-party transaction, according to Article 179 of the MITL; and
The methodology determined to analyse each related-party transaction, according to Article 180 of the MITL.
The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines) state that for related-party transactions, the amount of the transaction should be the same as that which would be agreed upon by a third party in similar circumstances.
In this sense, for taxpayers to determine that their income or expense is within the arm’s-length standard (in accordance with the arm’s-length principle), taxpayers are required to include as part of the contemporaneous transfer pricing documentation a detailed functional analysis by each type of transaction, and a robust economic analysis that includes an authorised transfer pricing methodology.
As seen before, the technical requirements established in the MITL are aligned with the general guidelines set forth by the OECD regarding compliance with the arm’s-length principle, and therefore it is expected that a transfer pricing audit will likely include questioning about how the taxpayer analysed the principle in a related-party transaction.
However, the previous considerations should be taken as a general basis for any given related-party transaction, since there are concepts that need to be considered and analysed for specific transactions before or during a transfer pricing audit. Two of the most common examples of intercompany transaction concepts challenged by the Mexican tax authority are financing and asset valuations.
Financing
Financing agreements are among the most reviewed related-party transactions in Mexico. The interest rate agreed upon by the related parties and the business reasoning behind the financing are concepts commonly challenged in tax audits.
It is important to mention that this trend in auditing financing transactions between related parties is not only exclusive to Mexico. In fact, the 2022 peer review of the OECD Guidelines includes an additional segment exclusive to the general framework to be considered in financing transactions between related parties.
In this sense, the OECD Guidelines mention that even before determining an amount (i.e., the interest rate) for the financing transaction, it is necessary to analyse if the transaction would be agreed upon within third parties, and to perform a thorough functional analysis to identify the characteristics of the financing transaction. This involves the following:
The economic reasoning behind acquiring debt;
An evaluation of the risks of financing for the lender;
The capability of the lender;
The terms and conditions of the financing agreement; and
From the debtor’s perspective, the availability of funds to pay for the principal and the interests incurred, and if there is a guarantee for the financing.
Once this first analysis is performed, to determine a transfer pricing compensation that complies with the arm’s-length principle for a financing transaction, it is necessary for a taxpayer to perform an economic analysis based on public comparable financing information such as identifying the maturity date, currency, guarantees, if the loan is subordinated, and the debtor’s credit score.
Additionally, it is important to consider any possible adjustments to the interest rate based on differences between the tested party and the potentially comparable information. For example, in Mexico it is common practice to include in some circumstances a country risk premium to the interest rate when the debtor is a Mexican entity, since most comparable information used in Mexican transfer pricing analysis is from the US and Canada.
In this regard, it is advisable for taxpayers to file all the information used to determine the financing transaction before, during, and even after the maturity date of the financing. This is relevant because, for example, the Mexican tax authority usually questions how the financing was used and why it was relevant for the debtor’s business, including invoices and additional support documentation to verify the reasoning behind it.
Asset valuations
With respect to tax audits including transactions of stockholders’ equity, and tangible and intangible asset valuations, it is imperative for taxpayers to prepare a file that includes the supporting information used for the valuation analysis, details of the calculations performed, the source of all the variables used to support the analysis, and other data. This file should also consider the background surrounding the valuation, agreements, a detailed explanation of the methodology selected for the valuation, and assumptions for the valuation.
Additionally, there are concepts in any valuation that are usually a matter for discussion with the Mexican tax authority, including the projected cash flows (assumptions, growth, period, etc.) used in the valuation, the discount rate, and its components, as well as, when valuing using comparable market information (i.e., multiples), the comparability of the information used and the date on which the information was obtained.
As such, given the inherent ambiguity of financial asset valuations, it is important to define from the beginning the scope, limits, and reasoning behind the valuation, along with filing all the information used to determine the value of the asset. The Mexican tax authority has even challenged the concepts used in financial valuations when the transaction was agreed upon within third parties, making it more relevant than ever to maintain the supporting evidence concerning the information used in every valuation.
Strict indispensability and effective provision of services
During a tax audit, there may be an (both for transfer pricing or others) exhaustive review on the concepts of strict indispensability, materiality, the effective provision of services, and non-duplicity between transactions. This is particularly relevant regarding transactions that represent a tax deduction for the Mexican taxpayer.
Article 27 of the MITL determines that for an expense to be considered deductible, the taxpayer must gather the following information:
The expense must be strictly indispensable given the economic activities of the taxpayer;
The expense must be aligned with a tax invoice; and
If the expense exceeds an amount of MXN 2,000, the expense must be supported by an electronic invoice from an account in the name of the taxpayer.
Additionally, for expenses with foreign related entities, the expenses could be accepted as deductible items if the taxpayer provides specific deliverables pertaining to the transaction.
In addition, it becomes relevant to prepare a defence file that includes an analysis of the expected economic benefit to validate that the related-party transactions are strictly indispensable given the economic activities of the taxpayer.
On the other hand, the OECD Guidelines establish that, to prove that an economic transaction was effectively provided, the first step is to determine if an independent party would be willing to pay another independent party for the transaction or whether the third party would execute the transaction internally. As such, to demonstrate that an intra-group service has effectively been rendered when asked by a tax authority, it is imperative to provide reliable information.
In this regard, when challenging the tax deduction for a service, a detailed explanation as to why the service was strictly indispensable is required. With regard to the effective provision of the service, invoices, login data, IDs, videos, photographs, manuals, flight records, occupancy, and other data pertaining to the personnel that provided the service are required.
With regard to non-duplicity of services, a common mistake is to generalise the description and concepts of the services received by the taxpayer, which, in the case of an audit by the Mexican tax authority, may lead to a misconception that the taxpayer is receiving the same service twice, and therefore it is considered non-deductible. Therefore, it is essential to differentiate the services received by the taxpayer from the beginning of the provision, to avoid additional enquiries.
Given the aforementioned, supporting documentation plays a fundamental role in demonstrating if a service transaction was effectively provided and there is a strict indispensability regarding the services received by the taxpayer. This supporting documentation should include contemporaneous transfer pricing documentation (a functional analysis, agreements, economic circumstances, etc.), deliverables, tax invoices, account statements, mail, presentations, and evidence of internal meetings.
Key takeaways
In conclusion, the tax and audit landscape in Mexico is becoming more relevant, especially concerning transfer pricing issues, and therefore it is advisable to develop robust defence files with supporting documentation for cross-border transactions, particularly for transactions that are more likely to be challenged by the tax authority, given their notoriety or relevance for the company.
It is also important to regularly update and improve the functional analysis for related-party transactions, since an in-depth functional analysis should improve and support the taxpayer position when involved in a transfer pricing audit.
