Cross-Border Transfer Pricing Investigations and Proceedings
As part of the G20/OECD project to avoid base erosion and profit shifting (BEPS), an action plan was developed to allow global tax authorities to pay special attention to transactions carried out between taxpayers and related parties. Further, these tax authorities have included diverse BEPS-related provisions in their local laws regarding transfer pricing.
Mexico has been actively involved in this project since it began in 2013 and, based on its recommendations, has enforced diverse transfer pricing provisions since the issuance of the new Mexican Income Tax Law in force as of 1 January 2014.
As a result of diverse economic and political factors, the Mexican tax authorities have adopted a very aggressive position towards a tax collection strategy through audits, specifically regarding transactions carried out by Mexican entities with foreign-based related parties.
The Mexican tax authorities’ recent audit procedures have been focused specifically on matters such as intercompany transactions carried out within multinational groups, value added tax refunds and the general disallowance of deductions requesting the fulfilment of excessive formal requirements.
These audit procedures have had a significant impact on the multinational groups in Mexico, which, in many cases – and derived from the representative amounts of the tax assessments – have resulted in corporate crises for Mexican companies.
Certainly, it is vital that these potential corporate crises are handled either through litigation mechanisms or alternative dispute mechanisms, such as mutual agreement procedures (MAPs) or conclusive agreements, which are further discussed in this chapter.
Furthermore, starting on 1 January 2020 and in connection with the BEPS action plan, a new obligation was included for Mexican taxpayers and advisers related to the disclosure of reportable schemes.
Specifically, the reportable schemes relate to transfer pricing regarding transactions that consider:
- the transmission of hard to value intangibles;
- business restructuring in which no consideration is established or where, as a result of such restructuring, the Mexican taxpayer reduces its operating profit by more than 20 per cent;
- no consideration is established for the temporary use of goods or rights, or services are rendered without consideration;
- there is no reliable comparable because the transaction considers unique or valuable functions or assets; and
- an advance pricing agreement (APA) granted by a foreign entity is used in the transaction.
This new obligation, which also includes the disclosure of other non-transfer pricing related schemes, is certainly a potential corporate crisis for Mexican companies.
Transfer pricing audit trends in Mexico
Recently, the tax environment has been characterised as aggressive, and audit procedures have focused on specific transactions with a clear and defined strategy for tax collection.
In general, the most commonly challenged transactions have been, among others, the payment of royalties in conjunction with advertising and promotion expenses, intra-group services (pro rata expenses), interest payments considered as dividends and geographic adjustments applicable for transfer pricing economic analyses.
Royalties, promotion and advertising expenses
In multinational groups, a company (the owner of an intangible asset) usually grants licences for the use of intangibles, such as trademarks or trade names, to related parties worldwide. As consideration for this licence, in general, a royalty payment is established, usually determined on an income-based consideration.
The licensees of these intangibles generally incur ‘promotion and advertising expenses’ to provide acknowledgment of the products or services they provide. This is to favourably influence its demand, facilitate the entry of new products on the market or increase the sales of existing products.
In general, and considering the applicable tax provisions, promotion and advertising expenses are considered deductible for income tax purposes and should be considered strictly indispensable for the purposes of the taxpayer’s activity. This is because the benefits from introducing an intangible to the market, such as a brand, are mainly related to the products or services that the licensee is offering. This benefit helps the licensee’s commercial activity, and usually either generates higher revenues or maintains sales in a competitive market.
Notwithstanding the above, the Mexican tax authorities’ general stance regarding companies that pay royalties in conjunction with local promotion and advertising expenses is that these royalties are not strictly indispensable for the Mexican taxpayer activities. This is because such expenses contribute to the value of the licensed intangible and, therefore, should be borne by the licensor (i.e., the owner).
Regarding companies that pay royalties in conjunction with promotion and advertising expenses, the position of the tax authorities is to reject the deduction of either of these expenses.
The Mexican tax authorities’ position regarding royalties, promotion and advertising expenses derives from a tax audit for fiscal year 2007 in which the Mexican tax authorities considered such expenses incurred by the taxpayer as non-deductible. From their perspective, these expenses were not strictly indispensable to carry out the taxpayers’ main activity owing to these promotion and advertising expenses being in connection with a trademark that was migrated abroad; therefore, the trademark was not the property of the Mexican resident.
In connection with this specific case, in 2011, through a first-instance decision, the Superior Chamber of the Federal Administrative Courts (TFJA) determined that promotion and advertising expenses were strictly indispensable, concluding, in general terms, that the promotion of the brands of which the Mexican taxpayer may identify its products was related to its corporate purpose.
Subsequently, in 2013, the Fourth Collegiate Circuit Court of the First Circuit decided on the appeal filed by the tax authorities to the resolution issued by the TFJA based on the following:
- the increase of the value of an external brand by means of advertising expenses was not indispensable for the development of the corporate purpose of the Mexican taxpayer;
- the direct beneficiary of the advertising expenses was the owner of the trademark, which is a different person from the Mexican taxpayer;
- advertising and promotion expenses of a trademark are only strictly indispensable for the owner of the intangible; and
- advertising expenditure is not considered a structural deduction because it is not closely related to the corporate purpose of the entity.
In general, the position of the Mexican tax authorities regarding royalties, promotion and advertising expenses is based on the above-mentioned elements of the decision issued by the Fourth Collegiate Circuit Court of the First Circuit.
It is important to keep in mind that this is an isolated circuit court precedent, which, based on our legal system, is not binding. Further, the decision was not unanimous, and was accompanied by a very well-reasoned dissenting opinion arguing that advertising and promotional expenses should be deductible.
To further confuse matters, the Superior Chamber of the TFJA recently issued another ruling on promotion and advertising expenses. It concluded that a licensee under a non-exclusive licence for the use and exploitation of intangible assets could not deduct promotion and advertising expenses. The court reasoned that, because the taxpayer does not own the licensed product brands, these expenses cannot be considered strictly indispensable to the taxpayer, as advertising these products would only increase the value of the brand to the benefit of a third party (i.e., the licensor). In this ruling, promotion and advertising expenses were defined as publicising a product in such a way as to attract customers through the means of media used to spread or disclose news of things or facts.
However, the Superior Chamber also ruled that the same company would be able to deduct marketing expenses, as these are considered indispensable for taxpayers because marketing provides conditions and means of distribution for products. Whether the company is the owner of the brand under which it sells its products was considered inconsequential.
These two decisions, specifically considering the definition of promotion and advertising expenses included therein, could be confusing for the purposes of determining the deductibility of certain expenses. Notwithstanding, it should also be taken into consideration that it is an isolated precedent, which is not binding.
Intra-group services (pro rata expenses)
Section 28-XVIII of the Mexican Income Tax Law (MITL) establishes that expenses incurred pro rata abroad with residents are non-deductible for income tax purposes. Further, in 2012, the Superior Chamber of the TFJA ruled in favour of a Mexican taxpayer in a case involving the deductibility of expenses incurred abroad on a pro rata basis.
This decision of the Superior Chamber of the TFJA was challenged by the Mexican tax authorities before the Collegiate Circuit Courts. The resolution of the Collegiate Circuit Courts determined that, since the MITL also disallows the deduction of pro rata expenses incurred with persons who are not income taxpayers (i.e., non-profit organisations), no discriminatory treatment existed.
The case was ultimately decided by the Supreme Court of Justice, where the Second Chamber ruled regarding the deductibility of expenses carried out pro rata, determining that the non-deductibility of pro rata expenses is not absolute and that Mexican tax authorities should review whether certain requirements are met for these expenses to be considered as deductible.
The requirements suggested in the aforementioned ruling included that:
- the expenses are strictly necessary;
- there is a reasonable relationship between the expenses incurred and the bene- fit obtained;
- the consideration should comply with the arm’s-length principle if the transaction was entered into between related parties;
- the tax authorities should be provided with precise information of the transaction; and
- certain supporting documentation should be stored.
Derived from the above-mentioned case, and specifically in connection with the decision issued by the Second Chamber of the Supreme Court of Justice, the Mexican tax authorities issued a miscellaneous tax rule establishing that the provision included in Section 28-XVIII of the MITL regarding pro rata expenses incurred with foreign residents would not be applicable provided all the following requirements are fulfilled:
- expenses are strictly necessary for the taxpayer’s activities;
- the entities with which the expenses are carried out are resident of a country with which Mexico has a broad information-exchange agreement;
- the service related with the expense was effectively rendered;
- if the expenses are incurred between related parties, the consideration established should lie within the range of considerations that independent parties in comparable transactions would have established;
- there is a reasonable relationship between the expenses incurred and the benefit received or expected to be received by the taxpayer. For such purposes, the taxpayer should comply with having an agreement that should disclose the details of the transaction, financial forecasts of the expenses to be determined pro rata, the explanation of the allocation methodology (which should reflect the benefit obtained) and expenses to be incurred, among other things; and
- certain supporting documentation is kept for each transaction in which the consideration is established pro rata.
This rule establishes that, if any of the requirements included therein are not complied with, expenses shall be subject to the provisions set forth in Section 28-XVIII of the MITL (i.e., expenses would not be deductible for income tax purposes).
As it may be observed, the requirements for considering pro rata expenses with a foreign-based entity as deductible have a great degree of subjectivity that, in turn, makes them difficult to fulfil.
This miscellaneous tax provision may place multinational companies located in Mexico, and that pay for certain services in which the consideration is determined pro rata, in a disadvantaged or risky position.
Interests recharacterised as dividends
The Mexican tax authorities have also reviewed interest payments made by Mexican entities to foreign-based related parties.
The MITL provides for the recharacterisation of interest payments in related-party transactions under different cases, such as the case of debt on demand, interest charges that are not in compliance with the arm’s-length principle and back-to-back loans.
In general, by means of challenging the strict indispensability or the interest charges established in the intercompany loans, or that fall into any of the re-characterisation cases, the tax authorities concluded that either all or part of the interest payments would not be deductible for income tax purposes and should be treated as a dividend payment.
The above-mentioned tax authorities’ position gives rise to significant tax contingencies.
According to the OECD Guidelines, arm’s-length prices may vary across different markets, even for transactions involving the same property or services; therefore, to achieve comparability, it is required that the markets in which the independent and associated enterprises operate have no discrepencies that could lead to a material effect on price or appropriate adjustments to be made.
As mentioned in Paragraph 1.110 of the OECD Guidelines, economic circumstances that may be relevant for determining market comparability include:
- geographic location;
- the size of the markets;
- the extent of competition in the markets and the relative competitive positions of the buyers and sellers;
- the availability (or risk thereof) of substituted goods and services;
- the levels of supply and demand in the market as a whole and, in particular, regions, if relevant;
- consumer purchasing power;
- the nature and extent of government regulation of the market;
- costs of production, including the costs of land, labour and capital;
- transport costs;
- the level of the market (e.g., retail or wholesale); and
- the date and time of transactions.
The OECD Guidelines establish that the facts and circumstances of the particular case will determine whether differences in economic circumstances have a material effect on price and whether reasonably accurate adjustments can be made to eliminate the effects of such differences.
As it may be observed, the OECD Guidelines broadly recognise the potential application of market or geographic adjustments when dealing with economic analysis of inter- company transactions.
Further, there is a lack of publicly available information in Mexico; therefore, for the purposes of performing transfer pricing analyses, comparable companies located in the United States are used. In this regard, Mexican tax authorities allow the use of foreign financial information to evaluate the transfer prices for Mexican companies.
Taking this into consideration, when dealing with transfer pricing economic analyses in which comparable companies from the United States are used for analysing transactions carried out by a Mexican entity, the Mexican tax authorities try to adjust the profitability of such comparable companies. In their view, an entity solely operating in Mexico should have a higher profitability than one operating in the United States, derived from the fact that the Mexican market is riskier than the United States.
The above-mentioned adjustment is achieved by means of increasing the operating profit of the comparable companies by adding a factor that considers the risks of operating in Mexico and the operating assets of the comparable company. This adjustment may seem subjective, since there are clear economic indicators that show that companies operating in Mexico incur higher costs in logistics, transportation and security, among others.
Likewise, the general profitability of Mexican entities is not necessarily higher than the profitability of the companies located in the United States. As an example, analysing the profitability of Mexican public entities measured by the returns of the Mexican Stock Exchange index regarding the returns of public companies in the United States measured by the S&P 500 index, it is not clear that Mexican entities have, in all cases, higher returns than companies in the United States.
The above-mentioned factors may lead to a difficulty in concluding whether the profitability of Mexican entities is higher than those of companies operating in the United States, and whether a geographic adjustment to the profitability of the comparable companies is, therefore, applicable.
Alternative dispute resolution
Taking into consideration the duration and costs of a litigation process, it is necessary to revisit alternative dispute resolution mechanisms when dealing with tax assessments or contingencies.
In this regard, the conclusive agreement, MAP and APA are alternative dispute resolution mechanisms commonly used by Mexican taxpayers.
The Mexican taxpayers’ ombudsperson (Prodecon) was established to provide legal certainty to taxpayers, grant free access to justice to taxpayers, assure equality between the taxpayer and government, and advocate for the taxpayers against arbitrary acts of the Mexican tax authorities.
One of the most important roles of Prodecon, which was introduced in 2014, is the conclusive agreement, which is a mediation type procedure, intended to provide a forum in which Mexican tax authorities and taxpayers may reach agreements in an audit or inspection procedure before a tax assessment is imposed. It allows for a negotiation between taxpayers and the Mexican tax authorities, assisted by Prodecon as a mediator.
When initiating a conclusive agreement, the form of an audit or inspection procedure is suspended; nevertheless, if an agreement is not reached through this procedure, the audit process will continue at the stage it was suspended. However, if an agreement is reached, it is binding on the parties and cannot be challenged. Also, partial agreements may be reached, leaving taxpayers in a position to challenge anything that was not covered by the conclusive agreement.
The settlement reached by both parties at the end of the conclusive agreement cannot be used as a precedent in any other judicial or administrative stages matters.
Pursuant to the provisions included in the Federal Tax Code, taxpayers who have executed a conclusive agreement are entitled, on one occasion, to a 100 per cent penal- ties reduction.
As mentioned, taxpayers may apply for a conclusive agreement at any time during an audit procedure and before the tax deficiency is notified to the taxpayers. To do so, the Mexican tax authorities must have made a description or classification of the facts or omissions identified within the audit process.
In this regard, for a taxpayer to apply for a conclusive agreement, three main requisites must be met:
- an audit procedure must have been initiated by the Mexican tax authorities;
- the Mexican tax authorities must have made a description or classification of facts or omissions identified within the audit procedure; and
- the tax assessment should not have been notified to the taxpayers at the time the application for the conclusive agreement is filed.
Once the conclusive agreement is filed, the parties (i.e., the taxpayers and the Mexican tax authorities) would not be able to establish contact directly, and such contact should be made exclusively through a formal requirement before Prodecon.
MAPs have been very effective when dealing with transactions carried out with foreign-based entities owing to the involvement of the tax authorities of both (or more) countries. This provides a global overview of the transaction and may mitigate a possible tax-aggressive strategy from a country’s tax authorities.
In connection with MAPs, Section 125 of the Federal Tax Code establishes that the dispute resolution mechanisms provided in the tax conventions entered into by Mexico are optional for taxpayers.
In this regard, the Model Tax Convention establishes that, where a taxpayer considers that the actions of one or both countries’ tax administrations result or will result in taxation not in accordance with the said tax convention, the taxpayer may request competent authority relief under the MAP article of the relevant tax convention.
Rule 2.1.32 of the Tax Miscellaneous Regulations 2017 establishes that an MAP request would not proceed when, among other things:
- it is based on a treaty to avoid double taxation (article or relevant part of said treaty) which is not in force;
- it is outside the deadlines established in the treaty to avoid double taxation;
- it is a matter of domestic law that does not contravene any provision of the treaty to avoid double taxation or deals with the application of the procedural provisions established by domestic law; or
- the subject of the request has been previously resolved in another procedure requested by the same taxpayer or a related party of said taxpayer regarding the same taxes, fiscal years, same circumstances and regarding the same article or relevant part of a treaty.
Unilateral and bilateral UPAs
Section 34-A of the Federal Tax Code establishes that the tax authorities may rule upon inquiries by interested parties, regarding the methodology used for determining prices or consideration amounts in transactions with related parties, provided that the taxpayer submits the information, data and documentation needed for the issuance of the corresponding resolution. These rulings may derive from an agreement with the competent tax authorities of a country with which Mexico has entered into a convention to avoid double taxation.
Rulings issued in accordance with Section 34-A may be valid regarding the fiscal year in which they are requested, the immediately preceding year and for up to three fiscal years following that in which they are requested. That is to say, APAs are valid for five years. Rulings may be valid for a longer period when they derive from a MAP in accordance with an international convention to which Mexico is a party.
Unfortunately, when Mexico signed the Multilateral Instrument, binding arbitration was not adopted, and even though in the United States–Mexico tax treaty it is an optional procedure, arbitration has never been used.
We hope Mexico changes the view against binding arbitration and it becomes a reality in the near future.
Court trends and precedents
In legal matters, there is an international and national trend that privileges the ‘substance over form’ and ‘legal truth’, which are divided in two aspects, one applicable to the administrative and the other to the judicial part – in both cases granting pre-eminence to substantive issues with respect to the legal form (substance over form).
In this regard, Article 17 of the Mexican Federal Constitution recognises the right of every person ‘to be administered justice by courts that will be expedited to impart it within the terms and conditions established by law, issuing its resolutions in a prompt, complete and impartial manner’.
Following the amendment of Constitutional Articles 16 and 17 on 15 September 2017, the first paragraph of Article 17 includes an obligation for the Mexican state authorities to privilege the settlement of disputes over procedural formalities, provided that equality between the parties, due process or other fundamental rights are not affected in the trials. This constitutional reform seeks to change the current model of administration of justice, forcing all authorities to study the conflicts that are brought before them, not only from a procedural practice, but also with the purpose of actually solving the problems, responding to the urgent need to resolve the substance of affairs, privileging the delivery of justice quickly and expeditiously.
Specifically regarding tax matters, Mexican federal courts have ruled that the substance or taxable reality must prevail over literal expressions or formal statements, taking into account the true economic nature of the facts contemplated by the tax rules so that there is a balance between the interests of individuals and the state.
The recent tax environment in Mexico has been characterised as aggressive, with thorough audit procedures regarding specific transactions with a clear and defined strategy for tax collection. Among the most audited transactions regarding transfer pricing are the payment of royalties in conjunction with advertising and promotion expenses, as well as the payment of services in which the consideration is determined on a pro rata basis.
Considering the duration and cost of the litigation processes, as well as these transactions being common within multinational groups, and Mexican courts being increasingly focused on the substance of these transactions over form, Mexican-based companies would be advised to opt for alternative dispute resolutions such as the conclusive agreement, MAPs and APAs. Because of the timing constraints often accompanying the request for a conclusive agreement, and to provide an adequate opportunity to select the most suitable alternative, we recommend defining a legal strategy and remedy no later than the audit procedure rather than after a tax assessment is issued.
Based on the international commitments entered into by Mexico within the OECD and other international forums, it is expected that, in the near future, these audit trends focused on international transactions will be maintained and probably increased owing to the amendments to domestic tax laws in force starting January 2020, and more specifically, regarding the disclosure of reportable schemes.