U.S. represents the most relevant foreign direct investor for Mexico while Mexico’s direct investment in the U.S. (stock) has increased significantly. In 2017 Mexico’s direct investment in the U.S. was of USD$18 billion(*). [*] , 9 January, 2019
Consequently, it is normal that the US tax reform has also tax effects in the other side of the border. For instance, the reduction of the corporate tax rate under the U.S. Tax Cuts and Jobs Act (TCJA) may trigger the application of the Mexican Controlled Foreign Corporations Rules (“CFC Rules”), deriving in more liabilities for the Mexican owners of U.S. entities.
Mexican tax residents are taxed under worldwide basis and profits of foreign entities owned by Mexican tax residents are generally taxable until such profits are effectively distributed. However, the Mexican tax law includes CFC Rules to limit the deferral of income tax in certain cases.
Mexican CFC rules apply when the revenues of foreign entities owned by Mexican tax residents are not taxed or are taxed in less than 75% of the actual effective tax that would be paid in Mexico and provided that such revenues do not derive from the conduction of business activities (active income).
However, revenues of foreign entities conducting business activities are also subject to taxation under Mexican CFC Rules if more than 20% of the total revenue corresponds to passive income. Under Mexican law, passive income includes interest, dividends, royalties, profit from alienation of shares, negotiable instruments, intangible assets, revenue from derivative financial transactionswhen the underlying is referred to debt or shares, the commission or mediation fees, or thealienation of goods that are not physically located in the country ofthe relevant entity, as well as the income derived from the alienation of real estate,from leasing of assets, or gifts.
Under the TCJA, the U.S. corporate tax rate was reduced from 35% to 21%; in comparison with the Mexican corporate tax rate which is 30%. So, now the question is whether such reduction in the U.S. corporate tax rate could trigger the application of the Mexican CFC Rules for those U.S. entities owned by Mexican tax residents.
The answer to the above question must consider different aspects as Mexican CFC rules are quite complex and to determine whether they are applicable, it is necessary to consider not only aspects of Mexican taxation but also of foreign tax systems, demanding a case by case analysis.Some of the aspects to be considered are the following:
- The reduction in the US corporate tax which now is 21%, represents less than the 75% of the Mexican corporate tax which currently is 30% (the 75% of 30% is 22.5%). However, to conclude about the application of the Mexican CFC Rules, we should refer to the actual effective tax paid by the US entity rather than only to the rate. The comparison between the actual effective tax to be paid by U.S. entity and a Mexican entity would demand to compare not only the rate also what is deemed accruable income and deductions, as well as the applicable credits, incentives, refunds, reductions, etc.
- Another fact to consider is that Mexican tax residents are only taxable at a federal level, while income of U.S. taxpayers is taxable at both, federal and local levels. The TCJA refers to the federal tax rate, but it is necessary to also consider the state taxes and the possible variations from state to state.
- The type of revenues earned by each entity must also be analysed. As mentioned above, the percentage of passive income regarding the total revenues of the entities are essential to conclude whether Mexican CFC rules apply.
But, what are the consequences of their application?
The main effect is that Mexican tax resident owners of foreign entities could not defer the payment of Mexican income tax. They would be obliged to pay income tax even if the profits were not distributed. If the foreign entity is a taxpayer in its residency country, the profits earned by such entity would be taxable as earned by a Mexican resident company, considering the corporate tax rate of 30%. Income tax paid abroad by the foreign entity may offset the income tax to pay in Mexico, in the proportion of the Mexican tax resident owner’s participation in the entity.
In addition, Mexican tax resident owners are required to file an annual report about the investments made during the previous tax year through foreign entities subject to CFC rules. Considering that the reduction of U.S. corporate tax under the TCJA is effective since January 1st, 2018, holding equity in U.S. entities that are subject to CFC rules must be reported in 2019 (no later than February). If the report is not properly submitted, the foreign entity’s profits would be taxable without deductions and the person liable of the omission may be punished with imprisonment for a term of 3 months to 3 years.
As we can see, breach of Mexican CFC rules could trigger not only tax but also criminal liability. To prevent such negative consequences and to ensure compliance with applicable Mexican tax legislation, Mexican tax resident investors should analyse their foreign investments and revenue, considering any amendment or fact that may vary their investments’ taxation.