Changing regulations: A look at recent tax reforms

On October 31, 2013, the Mexican Congress approved a number of tax amendments for the 2014 period, which went into effect on January 1, 2014. As a result of the different measures approved, the federal government expects to receive revenue of around MXN4.4trn ($341.9bn), which is 12.82% above the 2013 revenue budget.

The 2014 Federal Revenue Law used certain estimates and projections in the budget, such as an average dollar/peso exchange rate of $1:MXN12.90 ($1:MXN13.36 at the time of writing), an inflation rate of 3% (annualised at 4.63% at the time of writing), a projected average price for crude oil of $85 per barrel ($97.84 at the time of writing), 3.9% growth in the GNP (which in 2013 grew 1.3%), internal and external indebtedness of up to MXN570bn ($44.3bn) and $10bn, respectively, making up 16% of the total budgeted revenue. Estimated revenue arising from taxes, social security dues and government fees rose by 6.25%, 4.76% and 2.5%, respectively, from 2013. The principal increases are seen in a hike of 153% in excise taxes and a 23% boost in income tax. The tax amendments were clearly intended to increase the revenue available to support the new administration’s budgeted expenditures and were designed to reverse the trend in collections, which have been eroded over the last few years by incentives for investment, savings and the support of specific sectors.

The context of the tax amendments coincides with the commitments signed by the executive in December 2013 under the “Pact for Mexico” as concerns strengthening the state’s financial capacity and executing a comprehensive revision of public policy for the reduction of subsidies and the elimination of special regimes, with a view to establishing an efficient, transparent and progressive tax system.

One month into the application of the new tax law and, granted there has been a series of modifications and additional guidelines issued to ensure that the reforms can be fully applied, it is now evident that these reforms need to be evaluated in terms of their impact on domestic investors, and moreover on the international investment community and multinational corporations with local operations.

This new context will position Mexico further down in the ranking of countries measured by their total tax contribution (TTC), a fact that now requires that investors recalculate their expected return on investment. Hopefully, the increase in TTC can be offset by the number of other non-tax advantages offered by Mexico, which include the country’s very favourable manufacturing conditions and proximity to the largest global consumer market, i.e. the US. Thus, to understand what comes next, we must analyse what has changed in the Mexican tax rules.

INCOME TAX: A new income tax law has been approved, while the regulations applicable to the old income tax law will remain in effect to the extent that they do not conflict with the new law. Additionally, the new regime is not supplemented by the previously applicable cash-basis parallel system, since with the new income tax law came the repeal of the flat tax law (impuesto empresarial a tasa única, IETU), which was applicable until December 31, 2013. Another law that was repealed was the one concerning the tax on cash deposits (impuesto a depósitos en efectivo, IDE). The elimination of these laws will certainly simplify life for tax controllers in Mexico, which is great news, but it should be noted that some principles of the IETU were carried over into the new income tax law as discussed later.

Similarly, entities in the financial sector will continue to have the reporting requirements originally contained in the IDE, so movements of cash will need to be reported by banks even if they are no longer subject to the IDE.

ELIMINATIONS: The new income tax law eliminates, among others, the following special tax regimes: Tax consolidation: Although a new regime has been created for corporate groups wishing to defer income tax over a maximum of three years, transitional rules will be applicable for companies that are less than five years into the tax consolidation system. For others that previously suspended the group’s tax under the old consolidation regime, such tax will now be payable over the next five years in instalments of 25%, 25%, 20%, 15% and 15% of the suspended liability, and when paid, will be subject to inflation adjustments for the respective periods. Simplified regime: However, the following two regimes have now been created: a) Regime for land transportation (truckers); and b) Primary sector regime (agricultural, cattle breeding, forestry and fishing operations). Small taxpayers & intermediate individuals: A new mechanism has been created for their gradual incorporation into the general tax regime. Special regime for real estate investment firms: However, the real estate investment trusts will continue to be in place and publicly traded.

Additionally, the new law also eliminates the following deductions widely used for tax benefit: Immediate deduction of fixed assets (present value deduction of future depreciation): However, machinery and equipment for generating electric power from renewable sources or from efficient electricity cogeneration systems, as well as facilities for special-needs persons, continue to be entitled to the 100% deduction. Deduction of social security dues payable by the worker and absorbed by the employer: This benefit is usually granted as part of collective bargaining agreements, and the non-deductibility effect introduced by the new law will now have to be absorbed by the employer, possibly until new labour negotiations take place. 100% deduction of expenses incurred in the pre-operating period in the mining sector: Deductions designed to incentivise exploration. Global preventive reserves for credit institutions: Several important industries have been affected by the reform in a direct reflection of the executive and legislator’s intent of eliminating most tax incentives, which were viewed as excessively generous.

NEW TAX ON DIVIDENDS & CAPITAL GAINS: After many years of having a single level tax system, where dividends after tax earnings were no longer subject to tax, this year’s reform has introduced a shareholder dividend tax.

Accordingly, residents abroad and Mexican individuals will be subject to an additional 10% tax on dividends paid from profits generated as of 2014, applied via withholding by the distributing entity. This withholding will be treated as a final payment for these types of shareholders.

This new additional tax will also be paid by Mexican individuals when receiving dividend payments from companies resident abroad.

Furthermore, Mexican resident individuals will continue to be required to include dividend income in their tax returns and pay an additional 5% tax, which makes the TTC on dividends a 45% tax cost for these investors (see new tax rates for individuals later). Moreover, capital gains on sales through the stock exchange are now subject to a 10% tax. OTHER CHANGES TO SPECIAL TAX REGIMES & NEW LIMITATIONS ON AUTHORISED DEDUCTIONS: The new income tax law changes the rules for the following tax regimes and deductions: 1. Maquiladoras: The regime for maquiladoras ( factories that import and assemble duty-free components for export) is redefined. However, the negotiations between the Mexican executive branch and the Maquiladora trade group triggered by the reform have culminated in the issuance of a presidential decree, as well as certain other administrative rules issued by the Mexican Treasury.

These new rules contain provisions that in effect modify certain of the 2014 tax reforms’ provisions as originally approved to be applicable to the maquiladora industry, which were either considered difficult to satisfy or which required additional time to be fully implemented.

Nevertheless, in the context of all of the changes beyond their subsequent modification, the legislators’ intent to have the benefits only applicable to bona-fide maquiladora operations seems to have been achieved.

Thus, from 2014 maquiladoras will be required to export their full production, while their operation cost and TTC, as well as their permanent establishment immunity for the foreign principal, will eventually be similar to the pre-2014 conditions. 2. Limitation on deductions: In line with the recommendations issued by the Organisation for Economic Cooperation and Development as concerns base erosion and profit shifting (BEPS), the following assumptions have been included, under which several disbursements are not deductible. Interest, royalty or technical assistance payments made to a party resident abroad that controls or is controlled by the taxpayer, when: a) The company receiving the payment is considered to be transparent, except when the operation is carried out at market value and its stockholders or associates are subject to income tax on income received through the company located abroad; b) The payment is considered to be non-existent for tax purposes in the country in which the foreign party is located; or c) The foreign firm receiving the payment does not consider it to qualify as taxable income. Payments that are also deductible for a related party resident in Mexico or abroad, unless the related party includes income generated by the taxpayer in its own taxable income, in that period or in the following period. Also, additional rules were introduced to restrict the application of the benefits of Mexico’s tax treaties. 3. Contributions to pension funds & exempt salaries: Contributions made to pension and retirement funds as well as payments for remuneration qualifying as exempt income for the employee (welfare benefits, savings funds, severance pay, annual bonuses, overtime, vacation and Sunday premiums, among others that are partially or fully exempt) are deductible at the rate of 53%. The deduction is 47% when the taxpayer reduces exempt employee benefits from one year to the next. This new limitation seems to substitute a rule which was applicable to exempt salaries under the flat tax regime, which was altogether eliminated as of 2014.

Additionally, salary payments in excess of MXN2000 ($155) must be made through the financial system. However, this rule was relaxed through subsequent guidelines which now allow the employer to continue to pay wages in cash when necessary. From 2014 wages need to be supported by electronic receipts. However, a deferral in the obligatory application of this rule until April 2014 was introduced recently.

CHANGES TO THE TAXABLE BASE FOR ESPS: For 2014 the only differences between the tax base for income tax and employees’ statutory profit sharing (ESPS) are:

• ESPS paid in the period is not deductible for this proposal;

• Amortised tax losses are not deductible for ESPS;

• All salaries whether exempt or taxable are fully deductible for ESPS; and

• Depreciation is always claimed on a straight-line basis, even if incentive depreciation was claimed before for income tax purposes.

OTHER CHANGES AFFECTING INDIVIDUALS: In addition to the new tax on dividends and stock exchange capital gains mentioned above, individuals will be subject to the following: Tax rate increases: Applicable to individuals, the tax rate has been increased above the previous level of 30% via the addition of three new brackets, i.e. 32%, 34% and 35%, for annual income starting at MXN750,000 ($58,275), MXN1m ($77,700) and MXN3m ($233,100), respectively. Personal deductions: Total personal deductions are limited to the lesser of an amount equivalent to four annual general minimum wages for the geographic area of the taxpayer (MXN94,462.80, $7340, in Mexico City) and 10% of the overall income of the taxpayer, including exempt income. Donations are not included in that limit. Similarly, tuition fees up to the high school level will continue to be deductible by virtue of a presidential decree allowing it without regard to the minimum wage limit previously mentioned. Sale of a personal home: The maximum exempt transaction from the sale of a home is reduced to UDIS700,000 (previously UDIS1.5m), equivalent to around MXN3.5m ($271,950). Any transaction of a greater value is fully taxable on the profit generated on the excess over the exempt amount.

All taxpayers (including corporations, individuals and foreigners) will feel the effect of the changes since measures to boost administrative compliance were part of the modifications.

Some examples of these administrative changes include modifications to the payroll system to generate the new required electronic salary receipts. The need to establish records for all payments to nonresidents was introduced to be able to deduct them or to apply tax treaties. Similarly, the maquiladora industry will also be required to undergo a certification process to ensure proper compliance with income and indirect tax benefits.

For new investments it is important to further evaluate business projections to ensure that the higher TTC is duly considered alongside the positive outlook presented by the country’s favourable manufacturing, geographic and commercial climate.

OBG would like to thank contribution to THE REPORT Mexico 2014