Mexico’s tax system has been subject to dramatic changes over the years, resulting in an inefficient and misguided set of investment disincentives
It is likely that with the upcoming presidential elections in 2012, Mexico may see further substantial changes to its tax policy. The uncertainty of a solid economic recovery in Mexico until the US economy stabilises, coupled with the challenges faced by the Mexican government in its battle against the drug cartels may encourage the government to promote tax reforms in an effort to reinforce the country’s position in the international business community as having a competitive, yet stable and equitable tax regime.
According to the 2011 budget proposals, approximately 32 percent of Mexico’s annual spending is tied to revenues from the state-owned oil company, Petroleos Mexicanos. Most economists agree that Mexico must reduce its dependency on this company and increase its overall tax take by focusing on compliance and diversifying sources of tax income. Mexico’s total tax revenue as a percentage of GDP hovers around 17.5 percent: a rather low ratio compared with other OECD members, as well as to other countries in Latin America such as Brazil (currently 34.4 percent).
The current environment in Mexico includes tax assessments that may be large in Mexico because of interpretations of the law that are not always clear or in favour of the taxpayer, even in cases where tax planning is not involved.
Nevertheless, recently proposed reforms provide a framework for simplifying the system and laying the groundwork for positive changes that should relieve the tax environment in Mexico, increasing potential tax collections in a more equitable manner.
Mexico’s current tax system consists primarily of three main federal taxes:
Income tax is currently imposed at a rate of 30 percent to net taxable income. Taxable income is generally determined on an accrual basis. One of the unique characteristics of the Mexican income tax is its use of inflation accounting. The corporate income tax rate was increased temporarily – beginning in 2010 at 30 percent – and is scheduled to be gradually reduced back to 28 percent by 2014.
Mexico currently does not impose a tax on dividend distributions once the earnings are subject to income tax. Individuals pay income tax at graduated rates, up to the 30 percent maximum rate (also scheduled to go down to 28 percent by 2014).
Mexico is one of the few countries left in Latin America still requiring inflation accounting for income tax purposes. With inflation in recent years at close to five percent or less, the administrative cost for taxpayers to maintain the systems required for these calculations would hardly seem to justify the impact on the tax returns. Moreover, Mexican accounting rules have eliminated the need for inflation accounting, unless the inflation exceeds certain thresholds, leaving the inflation accounting requirement applicable exclusively for tax purposes.
A flat rate business tax is imposed on cash received from most business activities, less cash-based costs and expenses. This tax, in effect since 2008, is imposed at a rate of 17.5 percent. The income tax is creditable against this tax. Although the flat rate business tax works as an alternative minimum tax to the income tax, unlike alternative minimum taxes implemented in other countries, the flat rate business tax, once paid, is not creditable or otherwise recoverable against income tax.
Notable aspects of the flat rate business tax include the non-deductibility of interest and royalties paid to related parties. Although it has resulted in tax collections over the income tax base, since its inception it has consistently failed to meet the expected collection goals set forth in the annual budgets, generally by 25-30 percent. As a result, and given the additional compliance requirements it sets for taxpayers, many are of the opinion that the Mexican government should consider whether the IETU should be eliminated or, at a minimum, modified.
A value added tax is applied at a general rate of 16 percent to the sale of most goods and services. Notably exempt are food and medicines. Historically, the controversial issue for VAT each year is whether the taxable base should be broadened to include all goods and services.
In an attempt to fight perceived tax shelters the administration has established rules which adversely impact tax planning as well as possible new investment in the country. As mentioned above, the flat rate business tax disallows deductions for interest as well as royalty payments to related parties. This rule does not distinguish between types of royalties, which may include software or technical assistance subsequently sold to clients, thus resulting in almost a gross tax.
Mexican tax audits are becoming more common and taxpayers must carefully monitor the process as tax assessments will include penalties that can reach 100 percent, as well as inflation adjustments and interest that can average one or two percent per month. With these costs to contend with, taxpayers must carefully evaluate tax positions prior to implementing transactions or structuring operations. The tax law is, in some cases, unclear and subject to interpretation, which mkes the evaluation process complicated. For example, transactions such as warranty or guarantee expenses can fall within the definition of penalties or fines which are generally not deductible. This wording of the lawputs the deduction of common business expenses at risk.
Learn from the region
Recently proposed tax reforms attempt to simplify Mexico’s tax system, by eliminating the second tier of tax (the flat rat business tax). However, some of these proposals maintain the non-deductibility of legitimate costs of operating in Mexico, such as the cost of royalties. Mexico is, and will remain in the likely future, a net importer of technology and services. Although it should encourage local development of technology, it will not achieve that objective by simply punishing its importation.
Other countries in the region have been successful in raising tax revenues by leveraging the use of indirect taxes. For example, a common tax observed in several countries in Latin America is the tax on bank transfers. This tax has proven to be effective, as a permanent or temporary fixture in countries such as Brazil, Venezuela and Colombia. The effectiveness of this tax derives from its ease of administration, since the banks, which are part of the formal economy and are heavily regulated, collect and remit the tax, thus generating a reliable tax collection process with little incentive for non-payment. In the case of Brazil, the tax is designed to encourage longer term investment, by imposing higher rates on transactions which are likely to trigger instability for the currency.
Overall Mexico has a real opportunity with a new administration to make positive changes to its tax policy, offering increased stability and reassurance to otherwise concerned investors.