Evaluating the tax implications of M&A activity in Mexico

It is important when merging or acquiring shares or assets of a Mexican company that several methods are discussed and the varied tax consequences for each option are considered. For instance, if the acquisition of a target company is structured as a stock deal, the purchasing entity could benefit from existing tax concessions by not being subject to a value-added tax (VAT). However, if the target is brought in an asset deal, the specific assets that the buyer purchases may draw its own unique tax considerations.

While this only represents two key major merger and acquisition (M&A) avenues, this article explores the varied tax implications of this and several other acquisition strategies in Mexico.

In situations where a target company is acquired in a stock transaction, has pending tax losses to be carried-forward, and its income in the previous three years is less than the amount of its listed tax losses, its relevant tax losses can only be carried forward in order to offset tax profits that correspond to the same business activities from which the tax loss were derived.

The acquisition of a Mexican target company could also be structured as an asset deal. This strategy would allow the purchasing actor to handpick the assets deemed to be valuable for the operation of the target company, while discarding assets considered undesirable. In an asset deal, deduction and amortisation rules apply to the purchasing actor, with certain exceptions.

In situations where the target still has ongoing business, the purchasing actor involved in an asset deal could be held jointly liable for any and all tax liabilities existing prior to the acquisition for an amount that adds up to the entire value of the business.

Furthermore, existing tax concessions cannot be transferred in such deals, while VAT also applies on most transfers, including whenever real estate is involved.

There are a number of considerations when a Mexican target company is bought as a consequence of a merger.

Firstly, provided the entities involved in the merger are Mexican tax residents and that certain requirements are met, the transaction could be treated as tax-neutral. Secondly, the tax attributes of the merged company could be incorporated into the newly formed company. However, there are certain limitations that should be observed in this case.

For instance, tax losses generated at the level of the merged company would not be transferrable to the surviving entity. Likewise, tax losses of the surviving company could only be applied against profits deriving from the same type of business activities from which the first were generated.

In addition, anti-abuse rules apply on the acquisition of Mexican target companies where the only purpose is to take advantage of the tax losses.

Based on the above considerations, regardless of the method in which an acquisition is structured, it is of the utmost importance to conduct thorough due diligence to identify the strengths and potential liabilities of the transaction.

Furthermore, agreements should have adequate warranties in order to minimise the purchasing actor's exposure to potential liabilities and to entitle the purchasing actor to seek indemnity.

Mexican tax laws provide special tax treatment whenever real estate is involved in a transaction, triggering both federal and local taxes.

Depending on the structure of the transaction, it is also important to consider the step-up basis in stock deals, where no step-up in the tax basis can exist in the assets of the target company. A step-up could only occur regarding the consideration paid for the relevant stock (the price of the assets if the target company is not altered).

The tax basis in asset deals could be offset by certain deductions such as fixed assets, certain intangible assets, deferred costs or charges, preoperative expenses, technical assistance, or royalty fees set forth in Mexico's Income Tax Law.

Regarding corporate restructures, Mexican tax authorities may grant foreign residents authorisation for the deferral of the tax payable from the transfer of shares among companies belonging to the same group of interest. For this purpose, companies belonging to the same group are those where at least 51% of the voting stock belongs, either directly or indirectly, to the same parent.

This authorisation has to be obtained prior to the corporate restructure. The consideration stemming from the transfer consists solely of an exchange of shares issued by the legal entity that purchases the shares transferred.

Foreign investors should also consider the potential tax consequences that could arise depending on whether the acquisition is completed directly or indirectly. This is largely dependent on the vehicle used to acquire the target company.

If a non-resident investor decides to directly acquire a domestic target company, or uses another foreign legal entity or vehicle to do so, the wide range of tax treaties concluded by Mexico could provide relief for the allocation of resources between the holding legal entity and the target company. This may be applicable when dividends or interests are paid by reduced withholding rates, tax credits or even certain exemptions depending on the relevant treaty.

Regardless of the aforementioned considerations, it is important to note that in cases where a foreign investor directly purchases the assets that are essential for the target company, and decides to continue the merger or acquisitions, a permanent establishment (PE) for the non-resident could be set up nationally. Consequently, all income attributable could be subject to income tax in Mexico.

In cases where a foreign investor uses a Mexican legal entity to acquire stock in the target company, the cost of the transaction would firstly be generated at the level of the holding company. This is because the capital increase for purposes of the purchase would be generated at the level of the target company.

Such a transaction could either result in a positive or negative tax outcome, which is ultimately dependent on several factors including the financial position of the domestic target company. Therefore, the importance of conducting thorough legal and tax due diligence is once again emphasised.

When designing an investment strategy, non-residents should bear in mind that while Mexican tax residents (individuals or legal entities) are subject to income tax on a worldwide basis, foreign tax residents could be subject to income tax in Mexico for any income whose source is deemed to be located in Mexico, as well as any income attributable to a PE established nationally.

It is important to note that Mexican tax laws provide special tax treatment whenever real estate is involved in a transaction, triggering both federal and local taxes. Additionally, real estate in Mexico is subject to property tax in many states.

As a result, a transaction could be deemed to be sourced in Mexico whenever shares or securities are directly or indirectly derived from real estate nationally. This is the case even in situations where a transaction takes place between non-resident parties. Consequently, the relevant transaction could be subject to income tax in Mexico.

Furthermore, trusts whose purpose consists of acquiring and constructing real estate to be leased, or acquiring income derived from such leases, could be subject to a tax incentive under Mexican Income Tax Law. For instance, a real estate developer could deduct acquisition costs for land or lots used in the same year in which they are acquired.

Since 2016, the legal provisions that regulate these investment vehicles have been amended to address previous limitations, transforming it into an attractive option to invest in Mexico.

However, there are a few other real estate considerations. Mexican tax residents or even PEs of non-residents could be required to withhold income tax on transactions with non-residents. Additionally, individuals and legal entities that sell goods, render independent services, lease goods, or import goods or services on home territory could be subject to a VAT.

In certain cases, VAT ought to be withheld. For instance, whenever Mexican tax residents (individuals or legal entities) acquire or lease goods from a non-resident without a PE in Mexico, the relevant Mexican tax resident could be required to withhold. This is the same whenever a legal entity receives services from an individual.

Concerning withholding income tax, the corresponding rates can vary greatly depending on the transaction. Nonetheless, non-residents entering into transactions with a Mexican party should bear in mind that the broad range of tax treaties executed by Mexico could provide relief in the form of reduced tax rates, exemptions or tax credits.

With respect to VAT, the general tax rate is 16%. However, certain operations could be subject to a 0% tax rate or simply just exempt. Distinguishing between such operations is highly important given that only the first option would allow VAT crediting.

Non-residents should also be aware of the fact that specific legal presumptions are set forth in Mexico's VAT Law in order to determine when a transaction should be considered as being executed within Mexican territory, and thus subject to taxation.

In this regard, goods could be presumed to have been sold within the Mexican territory under the following conditions:

• If the relevant goods are located therein at the time when they are shipped to the purchaser;

• If no shipment has been made, and the seller materially delivers the relevant goods to the purchaser within the national territory; or

• Goods subject to Mexican certifications or registrations sold by a Mexican resident seller or by a foreign resident with a PE in Mexico could be deemed to have been sold on domestic territory in spite of them actually being sold abroad.

Concerning intangible goods, the transaction would be deemed to have taken place within Mexican territory if both the seller and purchaser reside therein.

Based on this framework, any transaction not performed within the national territory would not be subject to VAT in Mexico. Consequently, VAT could be mitigated or avoided based on the terms agreed upon by the parties. As a caveat, specific industries such as the maquila industry could be subject to VAT.

In general terms, the acquiring party could be exposed to the tax liabilities of a target company, so it is of paramount importance for adequate warranties to be incorporated into the relevant agreement in order to mitigate such contingencies.

In this regard, it is common for acquiring parties to negotiate indemnity clauses and, in some cases, for such indemnities to be backed-up with collateral or guarantees by the seller.

Furthermore, indemnity payments received both by Mexican tax residents and PEs of non-residents set up nationally could be considered taxable income. For foreign entities that receive indemnity payments, income tax due would be determined in consideration of the total amount of indemnity payments made in their favour by Mexican residents or non-residents' PEs located nationally.

It is also worth mentioning that indemnification payments are not deductible for income tax purposes, however specific exceptions apply.

It is important to take into consideration international trends and regulations. Mexican tax authorities have been addressing profit shifting in accordance with the OECD's BEPS Action Plan, with Mexican authorities playing closer attention to thin capitalisation, back-to-back and transfer pricing (TP) rules in any transaction.

Additionally, stringent requirements concerning interest payments have been incorporated. As a result, it is common for tax authorities to try to re-characterise interest payments as dividends in order to yield the tax treatment of the latter.

Mexico is also an active member of the OECD, and closely follows TP regulations given that tax authorities can initiate audits in cases where arms-length standards are not complied with, and discrepancies are believed to exist between the fair market value of a transaction.

Mexico also has an extensive tax treaty network and is constantly expanding it. Apart from tax treaties concerning the exchange of information, Mexico has executed more than 60 tax treaties for the avoidance of double taxation.

Finally, it is important to bear in mind that the general statute of limitations for tax liabilities in Mexico is five years.

However, if tax authorities consider that a taxpayer has deliberately failed to comply with certain formal tax obligations such as registering with the Federal Taxpayers Registry, keeping accounting records, or giving notice of any change of tax domicile, the statute of limitations could be extended to 10 years.

In addition, significant tax reform for the tax year of 2020 was published in Mexico's Federal Official Gazette, amending provisions of the Income Tax Law, the VAT Law and the Federal Tax Code, among other laws, on December 9 2019. Some of the main amendments concerning M&A transactions are briefly detailed below.

Although Mexican legislation contained measures against tax simulation, it had been deemed necessary to include a general anti-abuse rule (GAAR) to combat this problem more effectively and comply with the recommendations made by the OECD.

Under the updated Article 5-A of the Mexican Federal Fiscal Code, legal acts that lack a business reason but generate a direct or indirect tax benefit to the taxpayer may be reclassified by the tax authorities in order to assign the tax consequences that correspond to the acts that would have been performed to obtain the economic benefit reasonably expected by the taxpayer.

For these purposes, it is considered that there is no business reason when the quantifiable economic benefit, present or future, is lower than the tax benefit obtained. In accordance with the proposal, any reduction, elimination or temporary deferral of taxes is deemed as a tax benefit.

Finally, it is important to mention that under the proposed provisions, the tax authorities could presume, unless there is proof to the contrary, that a series of legal acts lack business reason when:

• The quantifiable economic benefit, present or future, is lower than the tax benefit obtained; and

• The economic benefit pursued could be achieved through the performance of a smaller number of legal acts and the tax effect would have been more burdensome.

In order to increase fiscal transparency, and following the recommendations made by the OECD, a new reporting obligation applicable to tax advisors and taxpayers was included in the Federal Tax Code.

In accordance with the reform, tax advisors are required to register before the tax authorities and disclose certain general and personalised schemes designed for their clients, as defined under Mexican law.

The term 'tax advisor' includes any individual or corporation resident in Mexico or resident abroad with a PE in Mexico that in the ordinary course of their activities are responsible for or involved in the design, marketing, organisation, implementation or administration of a reportable scheme, or the person who makes available a reportable scheme for implementation by a third party.

On the other hand, a 'reportable scheme' is considered to be any scheme that generates or may generate, directly or indirectly, a tax benefit in Mexico as long as it complies with any of the features established by law.

Some of the characteristics expressly listed include assumptions where the scheme:

• Consists of one or more transactions that allow the transmission of tax losses pending to be applied to persons other than those who generated them;

• Avoids the application of the provisions applicable to preferential tax regimes;

• Avoids to consider an expense as non-deductible for income tax purposes;

• Involves a taxpayer's change of tax residence;

• Involves operations connected to corporate reorganisations and restructurings;

• Involves the disposal and contribution of assets and financial assets;

• Includes operations involving capital reimbursements; and

• Involves transactions with related parties in which: intangible assets that are difficult to value are transferred, company restructurings are carried out in which there is no consideration for the transfer of assets, functions and risks, the temporary use or enjoyment of assets is transferred without consideration, or a unilateral TP protection regime is used; among others.

Click here to see the entire M&A guide from ITR

Ana Paula Pardo

Partner SMPS Legal T: +52 55 5282 9063 apardo@smps.com.mx Ana Paula Pardo is a tax partner at SMPS Legal. Her main practice is domestic and international, corporate and individual taxation. She regularly advises clients on matters involving commercial transactions, tax advisory, start-up businesses, joint ventures, investments, acquisitions, mergers, spin-offs, dispositions, tax-free reorganisations, and transfer pricing. Ana Paula has extensive experience with international transactions, corporate law, in representing multinational and domestic groups, tax controversy and litigation, and in tax audits and negotiations. She has a law degree from Universidad Panamericana and a postgraduate degree from the University of Salamanca. She also has an LLM from the University of Florida.

Jorge San Martín Elizondo

Partner SMPS Legal T: +52 55 5282 9063 jsanmartin@smps.com.mx Jorge San Martín Elizondo is a partner at SMPS Legal, and is both a lawyer and a certified public accountant. His practice is focused on tax and business advisory, and includes mergers and acquisitions and corporate reorganisations with a particular focus on permanent establishments and other tax-related international matters. Jorge assists his clients in structuring tax-efficient systems, including the tax treatment of acquisitions and investments. Jorge obtained his juris doctor from the National University of Mexico (UNAM), and is a certified public accountant from Universidad Anahuac del Norte from Mexico City. He is a member of Mexico's Public Accountants School and of the Mexican Institute of Public Accountants. He is also a member of the Canadian Chamber of Commerce and the American Chamber of Commerce in Mexico City.

Mariam Bojalil Lerch

Associate SMPS Legal T: +52 55 5282 9063 mbojalil@smps.com.mx Mariam Bojalil Lerch is an associate at SMPS Legal. She mainly focuses on tax advice in corporate and business matters involving national and international transactions, including matters of tax consultancy, international taxation, real estate planning, and corporate finance. She is also proficient on matters related to M&A, venture capital, commercial contracts and corporate restructurings. Mariam had previously worked in the corporate and foreign trade areas of Santamatina + Steta. She obtained her law degree in Universidad Panamericana and also took an international tax law course at New York University (NYU).