BAKER & McKENZIE ABOGADOS, S.C.

INTERNATIONAL TAX PLANNING CONSIDERATIONS FOR OPERATIONS IN MEXICO

Jaime Gonzalez-Bendiksen

INTRODUCTION

The purpose of this memorandum is to provide some comments on Mexican income tax matters which may have an impact on U S entities interested in investing or otherwise doing business in Mexico

AGENCY AND REPRESENTATION AGREEMENTS

The question most often raised by a prospective investor is whether one can do business in Mexico through a mere agent or representative or if one must establish a physical presence in Mexico through a branch or a subsidiary.

Operating through an agent or representative is certainly a possibility. Such a relationship would generally trigger no Mexican tax consequences for the foreign principal

We must note, however, that a true agent has a limited scope of activities. A foreign principal can typically have a purchasing agent, an agent to locate prospective purchasers, a sales representative who promotes the sale of products and sends purchase orders to the principal, a buy-sell distributor, or maybe an agent who renders services on the principal's behalf. But a foreign company usually would not act through an agent if it wanted to engage in, say, manufacturing

Certain activities of an agent can create a permanent establishment in Mexico for the principal. Namely, a permanent establishment will exist when the agent has, and exercises, the authority to execute contract or when he has a stock of goods that he delivers on behalf of this principal Similarly, a permanent establishment will exist whenever the agent does not have an independent status. Mexican tax law considers that an agent is not independent when he assumes risks on behalf of his principal, when he acts subject to detailed instructions and comprehensive control of his principal, when he performs activities which economically, belong to the principal, or when he receives compensation regardless of the outcome of his activities.

The US and Mexico entered into a Treaty for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Income Taxes (the "Tax Treaty") on, September 18, 1992, which changes some of the aforesaid rules The Tax Treaty, for example, provides that a permanent establishment will exist whenever the agent has and habitually exercises the authority to conclude contracts in the name of the principal (which means that a permanent establishment may exist even if the agent does not physically sign the contract); on the other hand. the Tax Treaty provides that keeping a stock of goods for delivery will not create a permanent establishment.

BRANCHES

Branches of foreign companies are subject to the general 34% corporate income tax rate, the same as subsidiaries of foreign companies. Thus. to this extent there is no tax benefit in either form of doing business in Mexico.

However, a branch does have a benefit in that it can deduct general administrative expenses incurred by the home office in Mexico or abroad. This is especially attractive for construction companies that typically incur extremely high expenses at the home office, which could not be taken as a deduction if the operations were conducted through a Mexican subsidiary

On the other hand branches cannot deduct payments made to the home office for royalties, commissions and interest Under the Tax Treaty such payments are deductible only when they constitute a reimbursement of actual expenses This limitation may be of special importance especially if the U S, in applying transfer pricing policies, would expect a US company to charge arm's length royalties to its Mexican branch if the latter uses industrial property, know-how, technology or technical assistance provided by the U S. company. If royalties must be charged, Mexico will tax the recipient, but, as indicated earlier, it will not allow their deduction by the branch. The practical effect will be that the royalties will be subjected to a kind of double taxation in Mexico, once to the home office (through a withholding tax, as discussed later) and once to the branch (by not allowing their deduction ) .

Perhaps most important. a branch is defined by Mexican income tax law as a permanent establishment of the home office. One of the effects of having a permanent establishment is that taxable income of the permanent establishment may encompass income from sales made by the home office in Mexico. It may also include other home office income if the permanent establishment shares in the expenses necessary to generate the income. Additionally, the tax authorities can impute income to the permanent establishment based on the profits generated by the home office. Thus the Mexican tax authorities may look at the ratio the branch assets and income represent with respect to, the home office's total assets and income in order to determine whether any additional income should be allocated to the branch.

This latter situation changes somewhat under the Tax Treaty, as only sales by the home office of the same or similar goods as those sold through the permanent establishment can be treated as income of the permanent establishment No income should be imputed where the home office demonstrates that such sales have been carried out for reasons other than obtaining a benefit under the Tax Treaty.

A final concern with branches does not involve taxes Foreign companies generally avoid establishing a branch because the branch, being a mere extension and the same legal entity as the home office. does not shield the home office from liability. Thus, any liability incurred by the branch, say for taxes, torts, contracts, labor. environmental provisions etc. could result in a direct action against the home office. Of course, in many cases this risk can be minimized by having the foreign entity incorporate a new company outside Mexico (i.e.. another U S company), with the capital and assets strictly necessary for the intended operation in Mexico. and having this new company be the one which establishes the branch in Mexico Under this set of facts the liability should not reach the parent company which owns the stock of the new company.

SUBSIDIARIES

Subsidiaries. of course present the opposite effects of branches Subsidiaries are entitled to deduct royalty, commission and interest payments made to their parent company but they cannot deduct any portion of the expenses incurred by the parent company. Furthermore, subsidiaries shield their parent company from liability because they are a new and different legal entity incorporated in Mexico and Mexico does not generally pierce the corporate veil

Mexico has different forms of legal entities, such as corporations ("sociedad anonima"), limited liability companies ("sociedad de responsabilidad limitada") and both general and limited partnerships ("sociedad en nombre colectivo y sociedad en comandita"). From a Mexican tax standpoint. all such legal entities are treated alike and all of them are considered Mexican taxpayers However, electing the appropriate legal entity may have considerable tax advantages (or disadvantages) if certain forms were to qualify as a "pass-through" entities for U S tax purposes

CAPITALIZATION

Once a decision has been made regarding the most suitable entity to do business in, Mexico, the issue is whether to fully capitalize the entity or to have it operate principally on the basis of working capital debt financing

Under Mexican tax rules, an entity may generate taxable income when it has debt

The reason is that if an entity owes. say. one million pesos on December 31 and it owes the same one million pesos a year later. it will owe less pesos in real or terms because of inflation. This means the entity has made a monetary gain and may have to pay taxes on the so-called inflationary profit

The opposite result is obtained when an entity owes one million dollars as of December 31 and it owes the same amount a year later, because of the likely devaluation of the Mexican peso vis-a-vis the US dollar the entity will owe more pesos for the same one million dollars. This is a monetary loss which is deductible and may help offset the monetary gain mentioned above. But to the extent Mexican inflation is higher than devaluation, the net result will be that entity will generate a taxable monetary gain.

TAXATION OF INTEREST

An additional deduction to offset the monetary gain could be the interest paid by the Mexican entity on the loan, whether to a related or unrelated entity or to a bank

However, such interest would be taxable in Mexico In general terms, the rate would be 4 9% if interest is paid to U S banks^l 10% if interest is paid In connection with financing supplied on the purchase of machinery and equipment² or 35% in all other cases, e.g. on interest for working capital paid to a related or unrelated entity.

These tax rates are based on the gross amount of interest, without deductions making them highly burdensome. Nonetheless, the 15% rate may prove advantage when interest is paid to a related entity, as the Mexican payor will be entitled to deduct the interest and will thus not pay its 34% corporate tax rate on such amount

The above rates apply only on arm's-length interest. Interest exceeding what would be an arm's-length amount or any interest paid under conditions differing from arm's-length principles will be taxable under the normal 15%, 21% or 35% rates set forth in the Mexican tax law

CONTRIBUTIONS IN KIND

Where desired, a US company could capitalize its Mexican branch or subsidiary not with cash but rather by contributing movable or real property, located either outside of Mexico or in Mexico.

Contribution of movables located outside of Mexico would be treated the same as a normal international sale, thus. it is not taxable in Mexico Furthermore, unlike other countries, even if the movables are located in Mexico. their contribution to a Mexican company by an entity which does not have a permanent establishment in Mexico would not be taxable in Mexico.

Contribution of land located outside of Mexico would not be taxable either. If the land is located in Mexico its contribution will be taxed as a sale at 20% of gross income or, under certain conditions at 34% of the net gain.

RENTAL OF GOODS OR LAND

Rather than contributing goods to the stated capital of the Mexican entity, oftentimes foreign companies elect to lease them to the Mexican subsidiary

This rate will be in effect until December 31 1995 After such date the rates under the Tax Treaty will apply namely 10% for three years and 4 9% thereafter

2 After December 31, 1995 the Tax Treaty rates will apply 15% for three years and 10% thereafter

In such case, the gross amount of the rental payment, for both movables and land will be taxed in Mexico at a flat 21% rate. Again, the Mexican entity will be entitled to deduct the rental payments for Mexican income tax purposes. This approach could mean a tax savings of 13% (the difference between the Mexican corporate tax rate of 34% and the 21% rate applicable to rental income) The taxpayer may also elect to be taxed at 34% of net gain on rental of land.

LICENSING

Royalties for intellectual property or know-how and transfer of technology are taxable in Mexico The tax is at a flat 10% tax on the gross amount of the royalties or fees paid by the Mexican company. As Mexican entities can typically deduct the royalty payments and consequently avoid payment of the 34% corporate tax rate on such amount a 24% benefit can be derived via the royalty payment (34% minus 10%) Again the 10$ rate will apply only to arm's-length royalties. Royalties exceeding what unrelated parties would charge will be taxed at the normal 15% or 35% rates established by the Mexican Tax Law

It is most important to note that payments from the rental of industrial, commercial or scientific equipment may qualify as royalty payments both under Mexican income tax law and under the Tax Treaty As such, these proceeds would be taxed at the 10% rate rather than at the 21% rate applicable to the rental of movables, discussed above. Proper drafting of the corresponding agreement may be helpful in achieving this result

Also of importance is the fact that under the Tax Treaty technical services fees are not taxable Thus. where an agreement involves both technical assistance and other concepts that are taxable, it would be advisable to split the payments corresponding to each in order to be able to exclude from taxation those payments corresponding to technical services

NONRESIDENT ALIEN TECHNICIANS

Typically. when a foreign entity is licensing technology and providing technical assistance. technicians are sent to Mexico to assist the Mexican licensee.

Such technicians could be subject to tax in Mexico on their earnings for work performed in Mexico Under the general rule in the tax law the technicians' salary would be taxed at the following rates:

the first Mex. Cy. $73.459 00 will be exempted;

salaries between Mex. Cy. $73,459.01 and Mex. Cy. $591,752 will be taxed at a 15% rate: and

salaries in excess of the latter amount will be taxed at a 30% rate

However, under certain conditions, if the days during which a person renders services in Mexico do not exceed 183 days in a 12-month period, that person shall be exempt from Mexican tax.

The above tax rates are not modified by the Tax Treaty. The Tax Treaty however, does have an important distinction in that taxation in Mexico arises only after 183 days of presence in Mexico, as opposed to the days-of-work in Mexico test which is applied under general Mexican tax law

DIVIDENDS

The Tax Treaty provides that dividends shall be taxed at a 5% rate if the beneficial owner owns at least 10% of the stock of the Mexican entity or at a 10% rate in all other cases Mexican law, however. has eliminated double taxation of profits. Profits are taxed in Mexico only once, either to the company or to the shareholders, but not to both. Consequently, with minor adjustments the after-tax profits that a Mexican operation generates and pays out as dividends are exempted from further tax in Mexico

Respectfully Submitted

Baker & McKenzie

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