Latin American Business Center Europe - Landwell Mexico: Investment Financing as a Tax Planning Tool

Proper financing of the acquisition of shares or assets in Mexico can represent tax savings of up to 44%.

In general terms, Mexico has a complex tax system, built upon federal, state, and municipal taxes. The pillars of the Mexican federal tax system are corporate and personal income tax, value-added tax, and asset tax (1,8% on business assets). There are also special taxes levied on production and services, public works, luxury goods, and vehicle ownership, among others. A notable feature is the payroll tax, which should be carefully considered when investing in Mexico. States and municipalities apply a property transfer tax, a property tax, and taxes on certain activities such as public events.

Regarding foreign investment, it is worth noting that, under domestic law, no withholding tax is levied on dividends distributed to non-resident shareholders. The country also boasts advanced Transfer Pricing regulations, which have served as a model for other Latin American countries. Furthermore, a Double Taxation Agreement with Spain is in effect.

Having reviewed the general aspects of taxation in Mexico, today we will analyze in particular the issue of financing an investment in that country. The case involves a Spanish company that decides to buy shares in a Mexican company to carry out its internationalization and expansion program in Latin America, financing the operation internally through a loan from one of the group's companies.

Since this is financing within the same economic group, we generally focus our attention on analyzing domestic tax rates and the International Treaties for the Avoidance of Double Taxation in force between the countries in question. This is good, but sometimes insufficient. Indeed, in some cases, such as the Mexican one, the most important thing is to analyze the legal and tax clauses of the loan to be made, since the possibility of generating a "hybrid" instrument—known in international taxation for the tax advantages it grants to both contracting parties—will depend exclusively on them.

In general, Mexican "hybrid" loans are loans between companies, with or without economic ties, in which contractual formulas are established that allow the sums paid by the Mexican entity to be considered as deductible interest; and, according to the law of the country of residence of the recipient of the benefits, dividends for the company that grants the loan, potentially generating a double tax benefit: the deduction of interest in Mexico and the receipt of dividends that may be exempt in the recipient's country of residence.

Having established this initial understanding of the concept, it is necessary to analyze Mexican law to determine which benefits derived from a loan are not considered interest and, therefore, cannot be tax-deductible. Mexican income tax law mandates that interest be reclassified as dividends when: 1) the loan agreement stipulates that it must be repaid at any time upon the lender's request; 2) the interest is not set at market rates; 3) it arises from a back-to-back loan; and 4) it is contingent upon the business's performance.

However, the opposite effect can also be obtained, classifying the payment as interest for tax purposes in Mexico and as dividends at the recipient's headquarters, incorporating the required clauses into the loan title.

Financing the acquisition of shares in Mexico through a "hybrid" instrument can result in tax benefits of up to 44%. This is because the deduction of interest paid in Mexico translates into direct savings on Mexican Income Tax (the rate in effect in 2003 was 34%), to which must be added the 10% employee profit-sharing. The desired outcome is achieved by optimizing taxation, as this payment can be treated as dividends in the investor's country of residence, allowing for the tax-free repatriation of profits from the Mexican subsidiary, depending on each country's domestic legislation.

As a negative aspect, it should be noted, among other less important ones, that the interest paid by the Mexican subsidiary to a beneficiary abroad will be subject to withholding in Mexico at a rate of 10%-15% if it is a country with a Treaty, 34% if it is not and 40% if it is a tax haven, generating a tax credit that, in principle, could not be imputed against said income in the country of residence of the recipient, if the interest reclassified as dividends has enjoyed tax exemption.

All these elements, and many more, must be taken into account when planning the tax implications of an investment in Mexico.