Recent developments regarding Mexico s tax treaty network and relevant court precedents Mexico has a relatively short background on the negotiation and application of treaties for the avoidance of double taxation. During the late 1980 s, Mexican foreign policy changed significantly, and led it to the signature of the North America Free Trade Agreement (NAFTA) with Canada and the United States of America (USA), which gave a new profile to Mexican economy. Likewise, in 1994 Mexico became a member of the Organization for Economic Cooperation and Development (OECD) and it also enacted the Law for the Agreement of Treaties. Mexico signed its first Convention for the avoidance of double taxation during the early 1990 s and since then, almost thirty four other countries have been included within its tax treaty network, making Mexico an attractive country for international investment. The majority of the aforementioned tax treaties have been executed based on the Model Convention of the OECD. During 2008, it concluded treaties with Barbados, Iceland and Russia, while it renegotiated its treaty with Germany and the Protocol of its treaty with the Netherlands. The treaty with Iceland and Russia entered into force on January 1, 2009, while the treaty with Barbados will become effective in 2010. Furthermore, treaties with Colombia, Hungary, Kuwait, Latvia, Lebanon, Malaysia, Morocco, Nicaragua, Panama, South Africa, Thailand, Ukraine and Uruguay are being negotiated. Regarding the new German treaty and the new Protocol to the treaty with the Netherlands, the corresponding notes have not yet been exchanged; however, this is expected to occur sometime during 2009, and thus be effective in 2010. Highlights of the new treaties IETU On January 2008, Mexico enacted its new business tax at a flat rate (IETU per its acronym in Spanish). In general, this tax is determined on a cash flow basis, decreasing the income obtained from the sale or disposition of property, the rendering of independent services and the granting of the temporary use or enjoyment of property by the expenditures required to carry out such activities. Since this new tax is creditable domestically against income tax, the question arose as to whether countries with which Mexico had negotiated tax treaties could recognize IETU as creditable in order to prevent double taxation, under the argument that it is a tax similar to income tax. Countries like Germany, Barbados, Brazil, Canada, Spain, France, Japan, the Netherlands, United Kingdom and Singapore, among others, have already recognized IETU as a creditable tax against their local income tax in order to avoid double taxation. On the other hand, the USA has expressed that it will evaluate the full operation of the IETU and its interaction with income tax, to determine whether IETU is a creditable income tax. Pending the conclusion of this study, the Internal Revenue Service will not
- 2 - challenge a taxpayer s position that the IETU is a creditable income tax under Article 24 of the USA-Mexico tax treaty. Mexico s latest negotiations have taken into consideration the foregoing; therefore the new treaties signed with Barbados, Germany, Iceland, Russia and the Protocol of its treaty with the Netherlands have included IETU in Article 2. Treaty Definitions Following the OECD s position that the meaning of terms not defined in the Convention would be that of the legislation in force when the Convention is being applied (when the tax is imposed), Mexico s new treaties provide for dynamic definitions when referring to residence. In most treaties, it is established that, where by reason of the provisions of Article 4, a person other than an individual is a resident of both Contracting States, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement and determine the method of application of the Convention to such person. Before, the residence of a person was settled attending to the place of its effective management. In the case of Barbados and Iceland it is established that a partnership is a resident of a Contracting State only to the extent that the income it derives is subject to tax in that State as the income of a resident, either in the hands of the partnership, or in the hands of its partners or beneficiaries. Regarding the new Protocol with the Netherlands, it provides that the benefits of the treaty are not applicable to companies or other persons that are totally or particularly tax exempt by a special regime. A special regime may be considered as such, only under a mutual agreement. Regarding the definition of permanent establishment, Iceland, includes in such term, among others, the rendering of services by an entity for a period or periods that collectively exceed a total of six months during any twelve month period. On the other hand, through the new Protocol with the Netherlands, in determining the existence of a permanent establishment it is provided that a person is understood to exercise the authority to conclude contracts in the name of the non-resident whenever it negotiates the essential elements of an agreement in name of the latter, even if the agreement is subject to final approval and signature by another person. Dividends In the case of Iceland and Barbados, the tax on dividends shall not exceed 5% of the gross amount of the dividends, if the beneficial owner is a company (other than a partnership) which holds directly at least 10% of the capital of the company paying the dividends. Iceland, will impose income tax at the rate of 15% on the gross amount of the dividends in all other cases, while Russia establishes a single 10% withholding rate. Bear in mind, that the Mexican tax legislation foresees that dividends paid by resident corporations are not taxable in the hands of the stockholder, irrespective of the residence of the recipient. Interests
- 3 - In the particular case of Germany and the Netherlands, the general rate is reduced from 15% to 10% of the gross amount of interest, and it is worth noting that the Netherlands included new definitions of the term interest that imply taxing amounts that were not taxable to date. In the new treaties with Russia, Iceland and Barbados, only a general 10% withholding rate is agreed. Notwithstanding the foregoing, in terms of Mexican legislation, withholding tax on certain interest could be as low as 4.9% (i.e.; interest paid to registered banks in a treaty country). However, it is likely that said rate will be eliminated in a near future. Royalties The treaties signed with Iceland, Russia, Barbados, Germany and the Netherlands establish that the tax so charged shall not exceed 10% of the gross amount of the royalties. In the case of Germany, the definition of the term royalty now includes payments of any kind for the use or right to use a person s name, picture or any other similar personality rights and on payments received as consideration for the registration of entertainers or sportspersons performances by radio or television. Capital Gains In the new Protocol with the Netherlands, an important amendment was made regarding capital gains. Under the treaty in effect, such profits are taxed at a 20% rate whenever the taxpayer holds an interest of more than 25%. Under the new Protocol, all capital gains will be taxed at a lower rate (10%), exception made of certain transfers among related parties, where the related gain, if any, would be exempt, provided the applicable requirements are met. Exchange of Information The treaties with Barbados, Germany and Iceland provide that they shall exchange information as is foreseeably relevant for carrying out the provisions of the Agreement or to the administration or enforcement of the domestic laws concerning taxes of every kind and description imposed on behalf of a Contracting State. It further provides that the States shall use their information gathering measures to obtain the requested information, even though the other State may not need such information for its own tax purposes, not being able to decline to supply information solely because it has no domestic interest in such information. Professors and teachers Treaties like the one with Barbados and Germany added an exemption for remunerations earned by individuals visiting a Contracting State at the invitation of that State or of a university, college, school, museum or other similar non-profit educational institution, or under an official program of cultural exchange for a period not exceeding two years, solely for the purpose of teaching or carrying out research in such institutions. However, the exemption does not apply if remuneration received for the teaching or research work is carried out for the individual s private benefit.
- 4 - Assistance in the collection of taxes Countries such as the Netherlands and Germany, added a new article that foresees the mutual assistance in the collection of revenue claims, including taxes of every kind and description imposed by a Contracting State, as well as interest, administrative penalties, and costs of collection or conservancy related to such amount. Other provisions In the case of Germany, the amendments include the elimination of the concept matching credit. Such amendment has been a recent tendency in the OECD, since it assumes that it is a mechanism that distorts the market. Also, it adds a new article for the Application of the Agreement in Special Cases in which it is established that the application of the Agreement shall not be interpreted to mean that a Contracting State is prevented from applying its domestic legal provisions on the prevention of tax evasion or tax avoidance; including the provisions regarding thin capitalization and preferential tax regimes. Relevant 2008 Mexican Court Precedents International Taxation Court Precedents Non-discrimination regarding information requirements with respect to payments made to non residents The Fourteen Circuit Court on Administrative Matters for the Federal District ruled that information requirements regarding interest payments made to foreign residents are not prohibited under article 22(4) Non-discrimination of the Mexico-Switzerland tax treaty. Mexican Income Tax Law requires for deducting interest payments made to nonresidents to annually provide certain information regarding the lenders and the loans thereof. Notwithstanding, a Mexican taxpayer failed to comply with such obligation, and the tax authorities disallowed the deduction of the interest paid to one of its foreign related parties, which was resident for tax purposes in Switzerland. Since the information requirement comprises only information regarding transactions entered into with foreign residents, the taxpayer claimed that the Mexican Income Tax Law was not applicable to the case at hand, pursuant to the non-discrimination provision contained in the Mexico-Switzerland tax treaty, which is in accordance with the OECD Model Tax Convention. The Fourteen Circuit Court concluded that information requirements are necessary to prevent international tax evasion, and therefore are reasonable. In this regard, it is important to mention that the 2008 Commentaries to the OECD Model Tax Convention include a commentary that specifically ratifies the decision made by the Court. This precedent is also relevant because the Fourteen Circuit Court also examined whether tax treaty benefits could be claimed by Mexican taxpayers in Mexico, and whether the non-discrimination provision could be invoked in transactions entered into with related parties, which were issues brought to Court by the tax authorities. Luckily, both issues were resolved in favor of the taxpayer and according to the international tax practice.
- 5 - Technical assistance as a business profit By the end of 2008, the Tax Court issued a very unfortunate precedent, where it ruled that payments made for technical assistance provided by a USA tax resident to a Mexican resident could not be considered a business profit under Article 7 of the USA- Mexico tax treaty. Therefore, it concluded that the payments made thereof should have been subject to withholding at the rate of 25% under the Mexican Income Tax Law. Due to a poor analysis of the Commentaries on the OECD Model Tax Convention, the Tax Court arrived at the conclusion that the commentary on Article 7 does not include technical assistance payments as business profits. Indeed, it failed to examine the commentary on Article 12, which clearly states that payments for pure technical assistance should be considered to be received as consideration for the provision of services that fall under Article 7. This precedent is not mandatory for other Courts or the tax authorities, and hopefully could be reverted at the appeal level by a Federal Circuit Court; however, it clearly will affect the short term tax authorities proceedings. It is worth mentioning that pursuant to a provision of the Mexican equivalent to the USA Revenue Rulings, the Commentaries on the OECD Model Tax Convention should be used to interpret and apply the Mexican tax treaties, even the one signed with the USA, as long as its provisions are similar to the Model Convention. Constitutionality issues It is common practice among Mexican taxpayers to challenge the constitutionality of tax provisions just after they are enacted by Congress. In fact, filing constitutional legal remedies (the so called amparos ) is an important issue within Mexican tax planning practice: first, an important tax refund could be involved as a result of a favorable outcome, and on the other hand, practically all of the taxpayer s competitors will file an amparo, and not being part of the same process could result in market disadvantages. Following is a brief summary of the most important decisions rendered by the Supreme Court of Justice during 2008 in connection with the constitutionality of the Mexican tax provisions. Mexican CFC rules As a result of five amparos filed by some of the major Mexican multinationals, during 2008 the Supreme Court of Justice ratified the constitutionality of the Mexican CFC rules, which abandoned the territorial anti-deferral system (black list) and adopted the preferential tax regime scheme. In general, effective January 1, 2005, the Mexican antideferral rules required to pay in foreign countries at least 75% of the tax that would have accrued in Mexico on passive income, obtained directly or indirectly in such foreign countries. The preferential tax regime rules established in the Mexican Income Tax Law in force during 2005 are similar to the current anti-deferral system; thus, no constitutional issues are pending resolution thereof. Notwithstanding the constitutionality certainty produced by the aforementioned Supreme Court decision, there is still a lot of uncertainty regarding the application of
- 6 - the Mexican CFC rules, due to its poor wording and its recent establishment, which requires a further analysis on a case by case basis. Transfer pricing best method rule The First Chamber of the Supreme Court of Justice also ratified the constitutionality of the transfer pricing best method rule in force in Mexico as of January 1, 2006. Under the Mexican Income Tax Law, the best method approach hierarchies the various transfer pricing methodologies approved for Mexican tax purposes, and gives highest priority to the Comparable Uncontrolled Price (CUP) Method. The constitutionality of said best method rule was challenged by a taxpayer, among other arguments, on the grounds that it violates its rights to continue applying any of the methodologies approved by the Mexican Income Tax Law, and also that it was not issued in compliance with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The Supreme Court of Justice ruled that the taxpayers had no right to continue applying any of the transfer pricing methodologies under the old provisions, since taxes are accrued on a yearly basis. Also, even though it was not a constitutionality issue, the Court ruled that the best method rule was issued in compliance with the OECD Guidelines, where it is established that the CUP method is the more direct and accurate methodology. It is important to bear in mind that the constitutionality of the Mexican transfer pricing rules has been a hot topic since the first arm s length rules were enacted in Mexico in 1992, but to date no case has been raised before the Supreme Court to examine the constitutionality of the whole regime. Nevertheless, from the best method case mentioned herein, it is possible to infer that the Supreme Court does not dislike the Mexican transfer pricing provisions, as they were issued in compliance with the OECD standards. Nonetheless, as in the case of the CFC rules, there is still a lot of uncertainty regarding the day by day application of the Mexican transfer pricing rules, which requires further analysis on a case by case basis.