2005 Mexican Tax Report. Gardere, Arena y Robles, S.C.

Transcription

1 2005 Mexican Tax Report Gardere, Arena y Robles, S.C. PREPARED BY THE MEXICAN TAX PRACTICE GROUP: Roberto Arena Reyes Retana rarena@gardere.com Fernando Camarena Cardona fcamarena@gardere.com Jorge San Martín Elizondo jsanmartin@gardere.com Javier Díaz de León jdiaz@gardere.com Paul Zev Nerubay Toiber pnerubay@gardere.com

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3 M e x i c a n Ta x R e p o r t Contents ECONOMIC PERSPECTIVES EXECUTIVE SUMMARY 2005 Income Tax 4 Tax on Assets 5 Value-Added Tax 5 Special Tax on Production and Services 6 UNCONSTITUTIONAL ISSUES VALUE-ADDED TAX Credit System 7 INCOME TAX LAW Thin capitalization 7 Cost of Sales 8 WORKER S PROFIT-SHARING Options 8 Sales of shares by residents abroad 9 Preferential tax systems 9 LAW OF FEDERAL INCOME FOR TAX YEAR 2005 Federal Income 10 Extension for payment of tax credits 10 Cancellation of tax credits 10 Tax incentives 10 Special tax on production and services 11 Tax on ownership and use of vehicles 11 Tax on Assets 11 Income tax 11 Exoneration of surcharges and fines 12 Federal Taxpayer Registry 13 - i -

4 G a r d e r e, A r e n a y R ob l e s S. C. INCOME TAX CORPORATE ENTITIES 14 Credit for taxes paid abroad 14 Tax rate 14 Decrease in Worker s Profit-Sharing 14 Calculation of PTU 14 Liquidation filings 14 Deduction for fuel 15 Deduction for salaries 15 Inventories that lose their value 15 Employment subsidy 15 Informational returns 15 Deferred expenses 15 Deductions for investments 16 Informational return on customers and suppliers 16 CUFIN 16 Cost of Items Sold 16 Option for valuation of inventories 19 Rendering of services 19 Inventory control obligations 19 Advance payments for acquisition of merchandise 19 Transitional system for cost of sales 19 Decrease of average of inventories in later periods 20 Merger and splitting of companies 20 Provisional payments 21 THIN CAPITALIZATION 21 Background. 21 Rules included in the LISR 21 TAX CONSOLIDATION 25 Consolidatable participation 25 CUFIN 25 Sales of shares 25 Tax on assets 26 Information in the audit opinion 26 Tax losses 26 Corporate dissolution 27 Change in share participation 27 Special consolidation concepts 27 INDIVIDUALS 27 Income from salaries and items includable as salary 27 - i i -

5 M e x i c a n Ta x R e p o r t Option to purchase shares 27 Provisional Payments 28 Employment subsidy 28 Income equalization subsidy 29 Annual tax payments 30 New tax obligations for workers and employers 30 Transitory provisions for fiscal year Transitory provisions for fiscal year Income from professional and business activities 31 Small taxpayer system 32 Income for granting temporary use or enjoyment of real estate 32 Income from sales of goods 32 Income from dividends 33 Other income 33 Requirements for deductions 33 Annual tax 33 FOREIGN RESIDENTS 34 Option to purchase shares 34 Income from fees 34 Sales of shares 34 Interest 35 Withholding on income subject to preferential tax regimes 35 Definition of business activities 35 PREFERENTIAL TAX SYSTEMS 35 TAX STIMULI 37 Immediate deduction 37 Deduction of land 37 Employer of persons with disabilities 38 Cinematic production projects 39 TAX ON ASSETS Deduction of debts 40 VALUE-ADDED TAX LAW Credit system 41 Small taxpayers 42 Crediting VAT for the Federation, states and municipalities 42 VAT Offset 43 Local tax 43 - i i i -

6 G a r d e r e, A r e n a y R ob l e s S. C. LAW ON THE SPECIAL TAX ON PRODUCTION AND SERVICES Seals on containers and cigarette packs 44 Exemptions for importation 44 New obligations 44 Transitory provisions 45 LAW OF THE OWNERSHIP OR USE OF VEHICLES TAX Calculating the tax 46 Simplified tax calculation 46 Electric and hybrid automobiles 46 Exemptions on importation 46 Restatement of values 47 ABBREVIATIONS 48 - i v -

7 M e x i c a n Ta x R e p o r t ECONOMIC PERSPECTIVES 2005 Since the 2001 slowdown, the world economy has seen a recovery characterized by continual accelerations and decelerations. These fluctuations were aided by lax United States monetary and fiscal policies that do not satisfy economic analysts and specialists, who hoped that the recovery would be smoother and more sustained, without interruptions by geopolitical events or abrupt movements in oil prices and financial markets. In 2004, the global economy experienced the greatest growth in recent decades, with the United States driving world demand, aided by China and Japan who in addition to contributing to the emerging Asian economies, are passing through one of the most brilliant periods in their histories. The war in Iraq, unrest in various producing countries, hurricanes, problems in refining capacity, insufficient reserves, lack of investment and the unforeseen demand for oil in China were fundamental factors causing crude oil prices in New York to reach record levels of $ at the end of October, with an increase of 60% during the year. Without a doubt, the current international situation is excellent. However, the persistent rise in oil prices over the year could have a negative effect on growth and inflation, although less so than in pre-vious energy crises. OECD GLOBAL ECONOMIC PERSPECTIVE EXPECTATIONS FOR THE GLOBAL ECONOMY (PERCENTAGE CHANGE IN GDP) OECD USA EU JAPAN MEXICO BRAZIL RUSSIA CHINA SOURCE: OECD - 1 -

8 G a r d e r e, A r e n a y R ob l e s S. C. In the United States, after having experienced more than 4% growth in 2004, the economic recovery is expected to lose strength in 2005, partly because of the rise in energy prices. These increases have hit consumers pockets directly and, given the low levels of consumer savings, it is very likely that this will slow private consumption. MEXICO Finally, we saw a strong recovery of Mexico s economy which was impelled by recovery of the manufacturing sector in the United States. This was reflected positively in our foreign trade and by high oil prices. Prospects for growth remain optimistic, since growth in internal demand tends to compensate somewhat for the projected decrease in international demand. Twelve-month inflation has increased in line with analysts projections from 3.98 to 5.43 percent through November, according to the most recent figures released by the central bank. The increase in the index is due in great part to increases in the prices of some fuels, meat and some agricultural products, in line with global trends. To contain expectations of inflation, the Bank of Mexico has acted appropriately though successive increases in the short to tighten monetary policy. PERSPECTIVES FOR THE MEXICAN ECONOMY 2005 CONCEPT /e 2005/e GDP Real Growth Rate 0.9% 1.3% 4.0% 3.5% Trade Balance Millions USD (7,915.8) (5,623.6) (5,390.9) (5,296.2) Net International Reserves Millions USD 49,000 57,435 59,500 62,500 Inflation End of period 5.7% 3.98% 5.52% 4.68% Mexican Treasury Bill 28 days End of period 7.0% 6.1% 8.5% 8.7% Mexican Treasury Bill 1 year End of period 9.8% 6.6% 9.2% 9.1% Exchange rate End of period SOURCE: INVEX Analysis Committee, Financial Group e = Estimate

9 M e x i c a n Ta x R e p o r t Among the possible factors that could change the macroeconomic scenario predicted for 2005, the following stand out: - International oil prices are at historically high levels. This situation, continuing for a prolonged period, could slow economic growth in the United States and, therefore, of the Mexican economy. - A tighter monetary policy in the United States. The elevated prices for energy and a decrease in labor productivity could upset the inflationary process, so that the U.S. Federal Reserve would feel obligated to toughen its policy, increasing interest rates on federal funds more aggressively, which would have repercussions on the U.S. growth and capital flows to emerging markets. This would affect Mexican exports, and the increased cost of external financing could generate liquidity problems in some Mexican businesses that will have significant financing needs in The lack of political agreements and the delay in the implementation of structural reforms could discourage the start-up of a number of important investment projects due to the uncertainty that would be generated among national and international investors. - More expensive internal credit. A significant increase in domestic interest rates could weaken internal spending, consumer as well as investment, and affect any economic expansion. From the tax point of view, the budget objective for 2004 will be easily reached thanks to greater oil income than expected. The excess funds obtained from petroleum income must continue to be used to consolidate government earnings. We insist on the importance of tax reform that permits increasing public finances, which is key to reducing vulnerability of public finances to changes in petroleum prices

10 G a r d e r e, A r e n a y R ob l e s S. C. EXECUTIVE SUMMARY 2005 The following is a summary of the most important changes as a result of tax reforms, the majority of which will become effective on January 1, Income Tax Changing income tax rates to establish a maximum corporate tax rate of 30%, 29% and 28% for fiscal years 2005, 2006 and 2007, respectively. This modification will also be included in schedules and fees applicable to individuals. Allowing income tax paid by a foreign company located in a second corporate level to be credited in Mexico. Allowing reduction of tax profit by the amount of profit-sharing paid to workers. Eliminating deductions for acquisitions of raw materials, finished or semi-finished products to allow the deduction for cost of sale. The mechanics of cost of sales will be applicable to various taxpayers. There are two calculations, one applicable to those companies that only carry out purchase and sales activities, and the other for those companies that engage in manufacturing. The rules for cost of sales will also be applicable for companies that render services. Through transitory provisions, inventories as of December 31, 2004 will not be deductible. Deduction of the cost of sale of this inventory will be permitted to the extent that the inventories as of that date are accumulated in various or successive fiscal years, depending on inventory turnover. New rules for thin capitalization are included, which tend to consider as non-deductible payments made for interest when the ratio of liabilities to capital is greater than 3 to 1. Non-deductible interest referred to in the previous point only will be that accrued in favor of related parties resident in Mexico or abroad, or in favor of independent parties located abroad when the taxpayer has related parties. The definition of deferred expenses is modified in order to also include as assets those things that permit using, enjoying or exploiting goods

11 M e x i c a n Ta x R e p o r t As of January 1, 2005, consolidatable equity will be 100% instead of 60% as was effective from 1999 to Therefore, several changes and adaptations to regulations will be made to incorporate the tax effects of this reform. The changes impose on companies that consolidate the obligation to disclose the amount of deferred taxes in all audited financial statements. If this information is not provided, un-consolidation will follow. The amount of profit received by an employee in exercising an option to buy shares granted by the employer or by a related party is now considered to be income similar to salaries. This will also apply to residents abroad. Beginning in 2006, the formula for determining income tax for individuals will be modified. This includes new concepts such as the general exclusion or employment subsidies and for equalizing income. Included in sources of income in Mexico is the sale of shares or securities issued by residents abroad whose presence in Mexico is represented directly or indirectly by more than 50% in real estate located in the country. The law includes a new definition of business activities. The purpose of this reform is to have fewer sources of income qualify as business benefits under the terms of the Treaties to Avoid Double Taxation entered into by Mexico. It incorporates a new concept of income subject to preferential tax systems. This applies when income tax incurred abroad is less than 75% of what would be paid in Mexico. Many investments made abroad will fall under this proposal. This also will apply to income obtained from local sources that fall under a preferential tax system. Tax on Assets The amount of debt contracted with businesses resident abroad and that contracted with the financial system can be deducted for purposes of calculating tax on assets. Value-Added Tax ( VAT ) The law modifies the formula for applying credits to VAT that is transferred to the taxpayer in a manner similar to procedure in effect until The tax transferred by disbursements related to investments must be adjusted in later years when the taxpayer carries out taxable and exempt activities. Operations that are not subject to VAT are included in determining the applicable rate

12 G a r d e r e, A r e n a y R ob l e s S. C. Special Tax on Production and Services (Impuesto Especial sobre Producción y Servicios or IEPS ) Exempted from the payment of IEPS are the importation of soft drinks, sport drinks, concentrates, powders, essences or flavor extracts that use only cane sugar as a sweetener, and that create soft drinks and other beverages upon dilution

13 M e x i c a n Ta x R e p o r t UNCONSTITUTIONAL ISSUES Value-Added Tax (VAT) Credit system The system for crediting VAT was substantially modified. We believe that this modification could be declared unconstitutional by our courts for the following reasons: (i) The modifications to the credit system were made by the Senate. However, Article 72, Clause H) of the Constitution of the United Mexican States declares that tax matters must originate in the Chamber of Deputies. (ii) In calculating the credit factor, one must consider within the total of all activities those activities that are not part of the taxed item. Above all, we believe that this change could violate the principle of tax legality, because the VAT Law does not define activities that are not subject to the VAT Law, leaving taxpayers with legal uncertainty. Further, in our opinion, the fact that activities that are not subject to the VAT Law violates the principle of tax proportionality by introducing a foreign element in determining the taxpayers creditable tax. (iii) The new credit mechanism applies an adjustment for investments not precisely identified with taxed or exempt activities (the factor for the month in which the credit is made must be com pared with the following months). Nonetheless, the VAT Law does not establish an adjustment for those taxpayers who have made disbursements related to investments that are 100% identifiable (whether with taxable or exempt activities). This could be a violation of the principle of tax equality of Article 31, Section IV of our Constitution. Income Tax Law (Ley del Impuesto Sobre la Renta or LISR ) Thin capitalization Regulation of thin capitalization in the LISR violates the principle of legality and legal certainty, because it does not clearly establish a regulatory standard. In effect, this regulation could lend itself to various interpretations, due in part to the fact that it includes undefined terms such as reasonable and capital. In our opinion, this violates the principle of legality and legal certainty. Further, the non-deductibility of interest could violate the principle of tax proportionality, because the - 7 -

14 G a r d e r e, A r e n a y R ob l e s S. C. corresponding debts could be necessary for the activity of the taxpayer. There would then be no reason to justify its non-deductibility (nor to perform a simple comparison between capital and debt). Finally, it establishes a transitional program for taxpayers to level their capital-debt ratio within the next five years. In this respect, we believe it appropriate to note that this program presents a reading that is subject to several interpretations. Therefore, it is our opinion that this violates the principles of legality and legal certainty. Cost of sales Beginning in 2005, in general terms taxpayers can claim their deductions not at the time the disbursements are made but at the time the sale is made. We believe that the new system could violate the Constitution for the following reasons: (i) The LISR includes various accounting concepts, which are not defined in the LISR itself. We believe that this could be a violation of the principles of legality and legal certainty. (ii) Beginning in 2005, the law establishes a tax incentive so that taxpayers dedicated to construction and sale of real estate developments could opt to immediately deduct the land acquired. However, for the rest of taxpayers the cost of sales system will be applicable. This could be a violation of the principle of equal taxation established in the Constitution. Workers Profit-Sharing (Participaciones de Trabajadores en las Utilidades or PTU ) Beginning in 2005, income that must be considered for calculating PTU will be modified. As of 2005, the PTU paid will not be deductible for purposes of calculating PTU. Because of this, we believe that the mechanism for calculating PTU will be subject to new injunction proceedings under the criteria previously issued in the past by Mexico s Supreme Court of Justice of the Nation. Options As stated in the corresponding section, the law establishes that individuals who are granted options to purchase shares pay income tax (as if it were salary) with respect to the presumed profit generated upon exercising the option. First of all, we believe that the fact that employees pay tax on exercising the option (and not when selling the shares) is contrary to the principle of tax proportionality because these employees do not change their equity until they sell the shares (and not when they acquire them). The profit that must be considered for tax purposes will be the difference between the value at which the option is exercised and the market value of the shares. To this effect, we believe that not establishing the - 8 -

15 M e x i c a n Ta x R e p o r t basis for the tax accurately (because the law does not establish how to determine market value), violates the principles of legality and legal certainty. Sales of shares by residents abroad Beginning in 2005, income received by residents abroad from granting rights of beneficial interests (including waiver of beneficial interests) or by use of shares or securities (provided that these shares or securities are considered as the source of wealth) will be treated as sales of shares. Income derived from legal actions in which partial or absolute right to receive yields from shares or securities will also be considered as sales of shares. In these cases, the tax must be paid by applying a fixed rate to the gross income. In other situations, provided that they fulfill certain requirements, the taxpayer could opt to pay the tax on the profit obtained. In our opinion, this could violate the principle of tax equality contained in our Constitution. Preferential tax systems As indicated in the corresponding section, in general terms, income is subject to preferential taxation when income tax applicable to this income abroad is less than 75% of the income tax incurred and paid in Mexico. First of all we could face a violation of the Constitutional principles of legality and legal certainty, because verifying how income earned abroad is taxed is not clearly defined. This could also be applicable to the assumption that regulates the 40% withholding on payment for income subject to preferential tax systems. Further, the new provisions concerning preferential tax systems could violate the principles of proportionality and tax equality, because these provisions take into account factors outside the jurisdiction of Mexican tax law (e.g. the income tax rate applicable abroad), because those who receive this income could be in the same circumstances as other taxpayers regarding their rights and obligations in accordance with Mexican law

16 G a r d e r e, A r e n a y R ob l e s S. C. LAW OF FEDERAL INCOME FOR TAX YEAR 2005 For the first time in several years, the Law of Federal Income (Ley de Ingresos de la Federación or LIF ) is published before the package of tax reforms that will be in effect, at least for On November 24, 2004, the LIF for fiscal year 2005 was published, which will become effective January 1, Below we present a summary and some of our comments on the most relevant provisions contained in the LIF. Federal Income According to the provisions of the LIF, the Federation will receive income during 2005 of $1,818,441,700,000 pesos. It expects to receive federal tax payments subject to participation of 1,065,564,800,000 pesos. Of this, $864,830,700,000 pesos will come from tax contributions. As in years past, it expects that the income tax produces the most income for the Federation is the LISR: $375,833,300,000 pesos. Extension for payment of tax credits During 2005, the extension rate for paying tax credits will be 1.5%. For late payment, the maximum rate applicable will be 2.25%. Cancellation of tax credits The ability or obligation of Mexico s Ministry of Finance and Public Credit through its Ta x Administration System to exonerate credits derived from tax payments or benefits is eliminated if the amount of the credit is less than or equal to 2,500 investment units in Mexican currency. Tax incentives The tax incentives provided for in the 2004 LIF will generally continue. There is, however, a new, relevant incentive for 2005, as follows: The law provides that tax incentive and terms will be granted based on economic efficiency, non-discrimination, defined time and progressivity

17 M e x i c a n Ta x R e p o r t Special Tax on Production and Services The special tax on production and services in the acquisition of diesel for final consumption may be offset against the VAT and withholding made to third parties on VAT or for income tax. A tax incentive is granted to taxpayers that acquire special marine diesel for final consumption and that will be used exclusively for fuel in vessels dedicated to carrying out merchant marine activities. This permits the crediting of an amount equivalent to the special tax on production and services that PEMEX and its subsidiaries have incurred from the sale of special marine diesel. Tax on Ownership and Use of Vehicles A new automobile tax incentive of the total amount of tax incurred is granted to individuals or corporate entities who sell to the general public or who permanently import under Mexico s Customs Law automobiles fueled by rechargeable electric batteries, as well as those electric vehicles that have an internal combustion motor (hybrids). A tax incentive is eliminated that agave producers were receiving in an amount not greater than $6.00 Mexican pesos per kilo of agave. This was used as a tax credit to decrease the payment of the special tax on production and services. Tax on Assets (Impuesto al Activo or IMPAC ) The Law grants a tax credit for investments in fixed assets to those taxpayers in the agricultural and forestry sectors. In addition, the taxpayers in the forestry sector can credit against the IMPAC the investments made in acquiring certain assets related to protection against forest fires. The law also establishes an IMPAC tax stimulus for General Bonded Warehouses for real estate owned, which is used for storage, safekeeping or preservation of goods or merchandise. An IMPAC tax stimulus of the total amount of tax incurred is granted to individuals who pay in the small taxpayer system referred to in the LISR. There is an IMPAC tax stimulus for assets the ownership of accounts receivable derived from contracts that taxpayers make with local branches of the Federal Government concerning the productive infrastructure investments dedicated to priority activities authorized by the Ministry of Treasury. Income tax For 2005, individuals paying under the small taxpayer system of LISR will be discharged of violations or

18 G a r d e r e, A r e n a y R ob l e s S. C. penalties from noncompliance with obligations, provided that these violations or penalties are not from more than two repeated events. Further, the Tax Administration System may grant to these taxpayers administrative terms to correct their tax situation. Exoneration of surcharges and fines Notwithstanding that the tax credits cannot be written off by the Tax Administration System independently from their amount and origin, there are transitory provisions that allow the Tax Administration System, through its Governing Board, to make new agreements with taxpayers in order to totally or partially forgive fines and surcharges with respect to tax credits derived from federal tax payments incurred before January 1, The measure granted the Tax Administration System the power to establish the type of cases or situations in which total or partial exoneration of surcharges and fines is granted. These must be published in Mexico s Official Gazette, and comply with the following guidelines: Partial or total exoneration will be granted by the authority taking into consideration the financial position of the taxpayer. The taxpayer must provide all documentation that the authorities consider necessary and, if the petition is accepted, must sign the agreement within 40 days after the date the documentation was presented. Partial or total exoneration will be authorized if credits were paid in installments under the terms of Mexico s Tax Code of the Federation. Forgiveness is also granted to credits that been appealed before the tax authorities or before the Federal Court of Tax and Administrative Justice. One can criticize the fact that within the situations included in the exoneration, there was no exoneration provision for defenses filed that are different from those indicated, such as an action for injunction. The Governing Board may agree to payment in terms of the tax credits related to surcharges and fines forgiven, and if the taxpayer cannot provide a guarantee, the tax authority may not request one. If the taxpayer does not comply with his obligations to pay under the agreement, the agreement will be voided as a matter of law. The competent tax authorities will immediately begin administrative enforcement proceedings. Partial or total exoneration of surcharges and fines will not be appropriate if: a) The determination of tax credits from which the fines and surcharges are derived imply the exis tence of aggravating factors in committing the violations. b) The credits were determined presumptively in accordance with Mexico s Tax Code of the Federation

19 M e x i c a n Ta x R e p o r t c) There is an executory judgment arising from the commission of tax crimes. d) It deals with taxes withheld or collected. The request for exoneration will not be a legal proceeding and the decisions may not be challenged through appeals. Federal Taxpayer Registry Mexico s Tax Administration System will implement a Program of Expansion and Updating of its Federal Taxpayer Registry, which will attempt to achieve complete compliance with tax obligations. This program will be carried out through inspections, invitations, requests for information, census or any other measure that the Tax Administration System has at its disposal under the provisions of the Mexican Tax Code of the Federation

20 G a r d e r e, A r e n a y R ob l e s S. C. INCOME TAX Corporate Entities Credit for taxes paid abroad The reforms incorporate into the LISR the ability of taxpayers to credit the taxes paid by companies that fall into the second corporate level against dividends received. This will be applicable provided that that corporate entity residing in Mexico has at least 5% of indirect equity in the company falling in the second corporate level. Tax Rate The income tax rate for corporate entities is reduced, with the goal of encouraging investment in our country and motivating savings. This should translate into a measure for creating jobs and improving salaries. The reduction in the income tax rate for corporate entities will apply gradually with the objective of cushioning the effect on tax collections. Therefore, the rate is reduced to 30% for tax year 2005, 29% for tax year 2006 and 28% for Decrease in Worker s Profit-Sharing (PTU) A very important and desired reform was to permit companies to subtract from their taxable income the amount of PTU paid during the year. It is hoped that this measure, together with the establishment of the 28% tax rate for 2007, the country will become more attractive for domestic and international investors. The decrease in PTU may be carried out with that generated as of January 1, 2005, to be paid in Calculation of PTU To calculate the PTU, therefore, the taxpayer cannot subtracts from the taxable profit the amount of PTU paid during the year. Liquidation Filings The provision establishes the obligation to carry out monthly provisional tax payments for the year of liquidation while the liquidation of the asset is taking place. There is special emphasis with respect to assets located abroad, which must not be considered for purposes of calculating the monthly provisional payments. These payments must be calculated in accordance with the provisions of the LISR that determine

21 M e x i c a n Ta x R e p o r t the factor and method of calculating monthly provisional payments for corporate entities that are not in the process of liquidation. At the end of the calendar year, the liquidator must file a return that determines and pays the tax corresponding to the period from the beginning of the liquidation to the last month of the calendar year, crediting the provisional and annual payments made related to this period. The final filing for the year of liquidation must be made within the month after the date on which the liquidation is completed for the company, and must include the assets located abroad. Deduction for fuel In order to discourage consumption of illegally obtained fuel, as of January 1, 2005, payments made for fuel (regardless of the amount) for maritime, air and land vehicles must be made by check in the name of the taxpayer, credit card, debit card or services card or electronic funds. Deduction for salaries In coordinating the new provisions on subsidies for employment and equalization of income, employment subsidies and income equalization must be paid in cash, and must be declared in an informative filing in order to deduct services. In addition, once obligated, employers must register the employees with the Mexican Social Security Institute. Inventories that lose their value As a consequence of the tax amendments for cost of sales, there is a provision to allow deducting the amount of inventories that have lost their value, if they comply with certain requirements. Employment subsidy The law provides that the amount delivered to the employee as an employment subsidy and to equalize income is not deductible. This provision seems logical, because the law permits taking a credit for it. Informational returns As of January 1, 2005, taxpayers will have complied with the requirement to file informational returns when they are filed within a term of 60 days from the date on which the notice is given by the tax authority. Note that LISR does not indicate in what cases the tax authorities must require these returns. Deferred expenses The definition of deferred expenses is modified to include intangible assets, represented by goods or rights that permit their use, enjoyment or exploitation. This modification has the goal of turning investment disbursements that are currently deducted as expenses into deductions, beginning January 1,

22 G a r d e r e, A r e n a y R ob l e s S. C. Deductions for investments In order to encourage the use of renewable energy resources that does not exploit nature, the law permits total deduction of machinery and equipment that generate energy from renewable sources, conditioning this deduction on operating the machinery and equipment for at least five years. In addition, 100% of adaptations made to facilities that are additions or improvements to fixed assets can be deducted, provided that these adaptations have the purpose of helping disabled persons to access and use the taxpayer s facilities. Informational return on customers and suppliers The law reestablishes the obligation to file information on operations with customers and suppliers no later than February 15 of each year, and not upon notification from the authorities as previously provided, in order to achieve an effective collection from taxpayers. Note that this obligation is not required for CUFIN (Cuenta Fiscal Neta or CUFIN ) As of fiscal year 2006, the PTU may decrease taxable profit. However, the PTU may not be subtracted from the total tax to determine the net tax profit for the year, nor to calculate a net negative tax profit. Cost of Items Sold Before beginning the explanation of the most important reform in the tax area for fiscal year 2005, it is worth reflecting on the tax system prior to fiscal year The ability of taxpayers in Mexico to deduct acquisitions of merchandise, raw materials, finished or semifinished products instead of cost of sales in Mexico, in addition to simple tax administration, made it possible for taxpayers to finance themselves through the public treasury by permitting immediate deduction in the year in which the item was acquired. As of January 1, 2005, cost of sales is considered as an authorized deduction. In general terms, the formula to determine the cost of sales, in accordance with accounting principles, is determined by adding to the initial inventory balance at the beginning of the year, the amount of purchase acquisitions, raw materials, finished and semi-finished products, manufacturing expenses and labor, less the amount of final inventory balance. The fact that to determine the cost of sales, final inventory balance must be subtracted means that those inventories can only be deducted once they are sold and not when they are acquired. It is very important to highlight that the added provision does not give the formula or mechanism related to the determination of the cost of sales, but is assumed to be understood

23 M e x i c a n Ta x R e p o r t The cost of merchandise will be determined in accordance with the system of absorbed costs over the base of historical or predetermined cost. The cost must be deducted in the year in which the goods are sold. In accordance with Mexican Generally Accepted Accounting Principles ( MGAAP ), absorbed costing is made up of all those direct disbursements and overhead incurred in the production process. Assigning cost to the product is done by combining direct expenses with the expenses from other processes or activities related to production. Therefore, the elements that form the cost of an article under this system will be the raw material, labor, direct expense of production and overhead, which can be variable or fixed. Historical costs, in accordance with MGAAP, consist of accumulating the elements of costs incurred for the acquisition or production of the articles. Predetermined costs are divided into estimated costs and standard costs. The former are based principally on the determination of costs based on experience from previous years or on estimates made by experts in the field. The latter are based on technical specification research on each particular product and experience, representing a measure of efficiency. It is important to point out that estimated costs like the standard costs must be adjusted in accordance with accounting procedures, against real cost. If there are differences, in the first case, they are known as variations that are adjusted directly in the calculation of the cost of sales. In the second case, the differences are known as deviations and must be charged to expenses for the year without affecting standard cost. In this last case, one could criticize the fact that the provisions do not clarify what happens with the differences from a tax perspective, because it could be that standard cost is less than real cost. If this is so, the law does not clarify what effect should be given to that difference. The law also provides that when the taxpayer decides to determine the cost by applying the direct cost system based on historical costs, it must be determined by including the raw material consumed, labor and manufacturing expenses, which vary in relation to volume produced. To exercise this option, the taxpayer must comply with the requirements established in the Regulations to the Law. Regarding the above, MGAAP provides that in integrating the cost of production by the direct cost method, the taxpayer must take into account the following elements: raw material consumed, labor and manufacturing expenses that vary in relation to volume produced. The added provision provides two procedures to perform the calculation of cost of sales, depending on the field in which the Company operates, as follows: 1. Taxpayers who carry out commercial activities consisting of acquisition and sale of merchan dise, will determine cost by including only the following: i) The amount of the merchandise acquisitions, decreased by the amount of refunds, dis counts and rebates over the annual earnings. ii) Expenses incurred in acquiring and preparing the merchandise to be sold

24 G a r d e r e, A r e n a y R ob l e s S. C. 2. Taxpayers who carry out activities other than those indicated in Number 1 above must include the cost only the following: i) Acquisitions of raw materials, finished or semifinished product, decreased by returns, discounts and rebates over the annual earnings. ii) Wages and salaries paid related to production or rendering of services. iii) Net expenses of discounts, rebates or returns directly related to the production or ren dering of services. iv) Depreciation or amortization of investments directly related to production or rendering of services. The concepts stated above that are indirectly related to production will form part of the cost in proportion to the importance they have in the production. Regrettably, the determination of the importance that these concepts may or may not have in the determination of cost evidently cannot be determined objectively, which leaves the taxpayer in a complete and total state of defenselessness and legal uncertainty. The residents with permanent establishments abroad or in the country will determine the cost of the merchandise in accordance with those provisions. The law also provides that taxpayers who carry out installment sales or who make financial leasing contracts and accrue the income when they collect, must deduct the cost of sales in the proportion that the income represents of the total agreed upon price. A transitory provision clarifies that the cost of sales will not be deductible on merchandise sold before December 31, The method of determining the cost must be applied in accordance with the same procedure for a minimum period of five years and may only be changed by fulfilling the requirements established in the regulations. It also provides that there is no tax effect on revaluation of inventories or cost of sales. The reform did not clarify what is meant by revaluation. On another matter, it provides that the methods for valuing inventories will be FIFO (First In, First Out), LIFO (Last In, First Out), identified cost, average or retail cost. It provides that those taxpayers who sell merchandise that can be identified by serial number and whose cost exceeds $50,000 can use only the identified cost method. It clarifies that the method of inventory valuation must be used for a minimum of five years. If there is a deduction generated as a result of a change in the method of valuation, it must be proportionally decreased over the next five years

25 M e x i c a n Ta x R e p o r t Option for valuation of inventories In another area, the law establishes a series of rules similar to those contained in MGAAP related to the determination of cost of merchandise. Here, it establishes that when the cost of the merchandise is greater than the market or replacement price, an adjustment can be made to the value of the inventories using replacement, realization or net realization value. This adjustment will have a direct impact on the determination of the cost of sales each time the inventory valuation is one of the components in the determination of this cost. If the taxpayers exercise this option, they will be able to modify the amount of the cost of sales by modifying one or more of the components (initial or final inventory). Exercising this option must be disclosed in the tax audit opinion filed, or if not, in the annual return for the year. Rendering of services Another provision states that those goods provided with any service will be deducted up to the year in which the income derived from rendering that service is accrued. Unfortunately, the provision does not clarify what happens when the accrual occurs over different years or at different times. Inventory control obligations The taxpayer must maintain control of merchandise inventories, raw materials, finished and semi-finished products in accordance with a continuous inventory system. This means that at all times the taxpayer must track the inventory. This control may be modified through fulfilling some rules. Those taxpayers that use the retail method to value their inventories must also maintain a record of the factors used to fix gross profit margins applied, identifying similar articles by groups or departments. Advance payments for acquisition of merchandise Until 2004, taxpayers had the right to take the deduction for the advance payments made to acquire inventory. Beginning in 2005, these advance payments may be included as part of the cost of sales when they are made when it is not possible to take the deduction immediately, as has happened until These advances include those related to costs of production. A transitory provision establishes that the amount of the advance payments as of December 31, 2004 will not be part of the cost of sales, and the difference between the value of the advance payment and the amount of the acquisition may be part of the cost of sales. Transitional system for cost of sales As a result of these modifications, the law provides that the stock in inventory that taxpayers have on December 31, 2004 will not be deductible. For these purposes, the first sold must be considered as the

26 G a r d e r e, A r e n a y R ob l e s S. C. first acquired. Notwithstanding the foregoing, there is the option for taxpayers to consider as a deduction the cost of sales to the extent that the amount of inventory is accumulated as of December 31, Base inventory that must be combined must be valued with the FIFO method. From the inventory the taxpayer has on hand as of December 31, 2004, the following must be subtracted: 1. The balance to be deducted from the final balances of the inventories from 1986 or 1988 related to the change of tax system from Title VII to Title II. 2. Tax loss carry-forwards. These may not be deducted in succeeding years. 3. The difference of the average of the last four months of 2004 against the last four months of 2003, if the former is greater. This difference must be accrued in Depending on the index of inventory turnover that each company has, the amount of the inventory must be combined. The index of inventory turnover will be determined by taking into consideration fiscal years 2002 to 2004, dividing the amount of the acquisitions of raw material, semifinished and finished products between the average of initial and final inventories for each year. The result of each year is added and divided by the number of years included. For taxpayers who began operations after January 1, 2002, only those years will be considered. The higher the index of inventory turnover, the faster the amounts of inventory must be accumulated. The terms for combining inventory run from four to twelve years, depending on the circumstances. Decrease of the average of inventories in later periods If final inventories as of December 31 of each year decrease with respect to the base inventory referred to above, the law establishes a mechanism that attempts to adjust the amount of combinable inventory for each year in order to anticipate the accumulation derived from the application of the schedule containing the accumulation periods. The procedure included is not very accurate and very unclear. Therefore, hopefully the tax authorities can issue rules on this matter. Merger and splitting of companies For company mergers, the merging company must continue with the process of accumulating the inventories of the merged companies. If the merging company has losses applicable, the merged companies must accumulate all of the accumulable inventories pending accumulation. For companies that split, the company that is spinning off and the spun-off companies will accumulate the pending accumulable inventory in the proportion that represents the sum of the value of the inven

27 M e x i c a n Ta x R e p o r t tories between them in accordance with the corresponding percentages. Provisional payments The amount that should be accumulated in each year must be taken into account for calculating the provisional payments. In this case, one twelfth must be considered for each month. Thin capitalization Background On November 26, 1986, the Board of the Organization for Economic Cooperation and Development (OECD) approved the text named Thin Capitalization, through which the OECD established the criteria regarding thin capitalization and its link in general with transfer price provisions. The OECD report on thin capitalization concluded that the arm s length principle is valid to determine if what is presented as a loan really should be considered as a capital contribution. This principle, applied to the theme of thin capitalization, establishes as a principal requirement the individual analysis of the maximum amount of indebtedness each company should incur, taking into consideration the amount of its capital (debt-capital ratio). The OECD report believes that if the loans exceed the arm s length principle, it can be assumed that there is an interest between the creditor company and the debtor company in the following factors: 1. Company profitability; 2. Profitability of its loan; and 3. Obtaining the interest. For member countries to correctly apply the arm s length principle to thin capitalization, and not follow internal rules that tend to be arbitrary, the OECD establishes in its report that if the total debt of a company exceeds a certain proportion of its capital (debt-capital ratio), then the interest on the loan or the interest on the excess of the loan should not be considered as interest, but rather should be treated as a dividend. Rules included in the LISR The rules for thin capitalization were included to slow down the over-indebtedness between related parties and, in this way, avoid the decrease of the tax base by financing a company through loans between related or independent parties, as well as to relocate tax profits and losses from one company to another. The thin capitalization rules included in Article 32, Section XXVI and in Transitory Article 3, Section III of the LISR are summarized in the following passages

28 G a r d e r e, A r e n a y R ob l e s S. C. All interest charged to the taxpayer, no matter if the source of the debts is with related or independent parties, is subject to the deduction limit in cases of over-indebtedness. The rule to determine if there is over-indebtedness is based on the comparison of the value of the debt that generates interest when it exceeds three times the sum of the shareholder equity (debt-capital ratio of 3:1), according to the taxpayer s financial statement, without considering the net profit or loss of the fiscal year. For purposes of determining the amount of the debts that exceed the limit indicated in the previous paragraph, subtract from the annual average balance of all debt the amount that results from multiplying by three the factor that results from dividing by two the sum of the shareholder equity at the beginning of the year and the end of the year. For purposes of the previous paragraph, taxpayers must determine the average annual balance of the debts, dividing the sum of the balances as of the last day of each of the months of the year among the number of months in the year. The two preceding paragraphs, through which the formula to determine the amount of debt that exceeds the debt-capital ratio of 3:1, can be summarized in the following procedure: (1) Annual average of debt: Sum of the debt balance / (divided by) 12 months = (equals) Average annual debt (2) Average shareholder equity: Shareholder equity at the beginning of the year + (plus) Shareholder equity at the end of the year = (equals) Sum of balances / 2 (divided by: two) = (equals) Average shareholder equity x (times) (3) = (equals) Shareholder equity to be subtracted from the average annual debt

29 M e x i c a n Ta x R e p o r t (3) Excess debt: Average annual debt - (minus) Shareholder equity to be subtracted from the average annual debt = (equals) Excess debt Once the amount of debt that exceeds triple the amount of shareholder equity has been determined, the amount of non-deductible interest will be determined by dividing the total of interest accrued in the year by the annual average balance of the debt. The result is multiplied by the amount of the debt that exceeds the limit referred to in the first paragraph (i) above. The calculation to determine the amount of non-deductible interest can be summarized in the following procedure: (4) Non-deductible interest: Interest accrued / (divided by) Average debt balance = (equals) Percentage (factor) x (times) Excess debts = (equals) Amount of non-deductible interest By strictly applying the result of the calculation above, without examining the reason and scope that the thin capitalization rules established in Article 31, Section XXVI of the LISR must have, we could arrive at the illogical conclusion of considering as part of the non-deductible interest not only interest accrued in favor of related parties, but also that interest accrued in favor of independent parties, including residents in Mexico. This is due to the fact that the calculation described above does not only include the interest accrued with related parties or the debts with related parties. Therefore, we believe that the amount of nondeductible interest cannot be greater than the amount of interest accrued in favor of related parties or in favor of independent parties who reside abroad when the taxpayer has related parties. Another interpretation could lead us to conclude that the amount of non-deductible interest is the interest accrued in favor of related parties or independent parties residing abroad when the taxpayer has related parties, in the proportion that the debt contracted with these related or independent parties exceeds the shareholder equity of the company, and that the mechanism mentioned above is only a maximum amount of non-deductible interest. The lack of clarity in these provisions will surely generate the issuance of rules to clarify these imprecisions