MEXICO: An Introduction to Tax: Controversy

Mexico: Tax controversy 

Ortiz Abogados Tributarios 

Among the OECD member countries, Mexico has the lowest tax collection in terms of GDP ratio. OECD’s collection average is 34.2%, while Mexico collects an amount only equal to 16.2% of its GDP.

This has created significant pressure among the Mexican state to improve the collection rate, but without paying the political cost to implement a substantial tax reform.

The Federal administration that took office on 1st December 2018 proposed two relevant promises, among others: to increase public spending to support low-income families, students and senior citizens; and not to create new taxes, nor increase the existing ones.

Therefore, the Mexican Tax Administration Service, known as SAT for its acronym in Spanish, has focused its efforts in auditing high income taxpayers. During 2020, the SAT was able to reach agreements with high profile companies in order to collect large amounts that were being challenged in courts and that were in the process of being audited and assessed.

Because of said audit policy targeted on relevant taxpayers, tax collection increased significantly during 2020, although Mexican GDP fell around 8%.

SAT auditing guidelines are focused on three main strategies: (i) preventing taxpayers from eroding their taxable base with simulated transactions, (ii) transfer pricing issues, (iii) addressing aggressive tax planning.

The first strategy was implemented in response to a harmful avoidance practice adopted by many taxpayers: to issue invoices without providing any service or selling any assets or goods, in exchange of a specific compensation.

Nevertheless, in practice SAT auditors regularly demand excessive requirements and conditions sometimes impossible to fulfil from taxpayers to demonstrate the actual provision of a service or the acquisition of assets or goods, to take the deduction for income tax purposes or the crediting of the input VAT. Therefore, audits result in assessments in which deductions and input VAT are rejected.

From the SAT’s perspective, transfer pricing audits have become an efficient way to increase collection and prevent tax avoidance. These audits tend to be complex and usually have a lack of rigid criteria to value a specific transaction.

Therefore, transfer pricing audits usually result in an assessment against the taxpayer, unless controversies are settled in an alternative dispute resolution procedure before the assessment is issued.

In order to address aggressive tax planning, Mexican legislation has adopted several recommendations of multiple BEPS action plans, such as:

(i) The non-deductibility of payments made directly or indirectly to related parties whose revenue is subject to a preferential tax regime.

(ii) The non-deductibility of interests paid to related or independent parties, if they exceed an amount equal to 30% of the adjusted tax profit.

(iii) The obligation for tax advisors to disclose to the tax authorities any structure for aggressive tax planning in which they participate, either by designing or implementing them, if they are identified as risky transactions.

(iv) A general anti-avoidance rule, according to which, SAT is entitled to ignore the tax effects of legal acts lacking a business reason, but that create a tax benefit for the taxpayer.

(v) New rules regarding the taxation of foreign fiscal transparent entities and disregarded entities in Mexico, and the taxation of revenue obtained by a Mexican resident whose origin is a foreign fiscal transparent entity or a disregarded entity.

If an audit process that follows one or several of the aforementioned strategies, or any other adopted by the authorities, ends in an assessment, taxpayers are entitled to challenge it. This can be done through an administrative appeal before the tax authorities or an annulment complaint before the Federal Court in Administrative Justice, the tax court, and as an appeal remedy to the Federal Courts of the Judicial Power.

According to Mexican law, tax assessments are presumed to be lawful and valid, therefore, the burden of proof relies on the taxpayer. For this reason, the taxpayer is compelled to demonstrate that the legal provisions have been wrongly applied or interpreted, or that the facts were unduly appreciated or proved by SAT’s auditors.

Despite the lack of reliable statistics, the general perception among tax controversy practitioners is that the ratio of successful litigations before the courts has dramatically decreased in the last few years.

For this reason, taxpayers and practitioners have looked for alternative options to find a reasonable solution to their day-to-day struggles with the tax authorities. A first path to follow is to have intensive assistance at the audit stage from tax lawyers in order to submit a robust amount of documentary evidence and legal reasoning to sustain the company’s position. The foregoing of which, due to a recent precedent issued by the Mexican Supreme Court of Justices, in which it states that the evidence that was not provided by the taxpayer during the audit will not be accepted at the courts in case of a judicial claim.

A second option used by the taxpayers is the alternative dispute resolution mechanisms provided by Mexican law. Taxpayers are entitled to request the Mexican Taxpayers Rights Defence Agency, known as Prodecon for its acronym in Spanish, to execute its mediation faculties in order to procure a settlement between the private company and the SAT.

The adoption of a conclusive agreement has resulted in an effective instrument to find a consensual solution to controversy, and to adopt a mutual position regarding the nature and tax effects of specific transactions. Although the agreement must be supported with evidence and technical elements, tax controversy practitioners have been forced to develop negotiation skills, in addition to their litigation capabilities.

A relevant element to take in consideration is that, as of 2020, Mexican laws establish more severe sanctions to the taxpayers who avoid their fiscal obligations, especially to those that issue invoices without providing any services or goods, and to those that erode their taxable base by said invoices.

Relevant penalties do not only include the cancellation of the electronic seals to issue invoices, but also criminal penalties as these transactions are deemed as felonies that deserve preventive prison.

Following the mid-term elections that took place in June 2021, the Mexican President ratified his commitment not to create new taxes nor increase the existing ones. Therefore, for the 2022 fiscal year we may expect a tax reform that focuses on improving collection, specifically to high income taxpayers by closing loopholes and addressing aggressive strategies.

The official target is to increase the effective tax rate to be paid by taxpayers. Effective tax rate is understood as the paid amount of income tax divided by the total amount of taxable revenue obtained in a fiscal year.

In fact, according to an amendment to the Federal Tax Code in force as of 2021, the effective tax rate that is considered appropriate for taxpayers in 40 specific business activities was made public by the SAT. According to Mexican legislation, taxpayers that do not comply with said parameters will be considered as a tax risk and invited to self-correct their situation under the implicit threat to be formally audited and possibly assessed with a tax liability.

In this scenario, according to the elements described in the previous paragraphs, we may expect an intensive use of the legal instruments granted by the law to the tax authorities. This will require taxpayers to have the advice of highly prepared controversy practitioners.