New Protocol to Mexico-Spain Treaty to enter into force

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1 24 July 2017 Global Tax Alert News from Americas Tax Center New Protocol to Mexico-Spain Treaty to enter into force EY Global Tax Alert Library The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Tax/Americas-Tax-Center---borderlessclient-service Executive summary On 27 June 2017, the governments of Mexico and Spain exchanged the final note of ratification of the protocol amending the convention between Mexico and Spain for the avoidance of double taxation and its protocol (the Protocol), which was approved by the Mexican Senate on 16 April According to the provisions of the Protocol, new rules will enter into force as of 27 September 2017 (i.e., three months after the final exchange of notes of ratification). Further, rules dealing with withholding taxes including withholding on dividends and interest payments will also go into effect beginning 27 September Rules dealing with all other relevant income tax issues will become effective beginning 1 January Although the changes to the Convention include enhancements on benefits for withholding taxes and other provisions, the Protocol also includes an anti-abuse clause in the form of a Principle Purpose Test (PPT) which is aligned with the one set out by the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS 1 (the MLI). See EY Global Tax Alerts on Mexico 2 and Spain 3 for further details on each country s positions, as provisionally notified on 7 June 2017.

2 2 Global Tax Alert Americas Tax Center The main changes to the Convention include: Enhancements on benefits for withholding taxes: Dividend income: 0% for dividends derived from (i) qualifying participations (i.e., more than 10% direct participation in the share capital of the paying entity) (formerly 5% with more than 25% direct participation) and (ii) pension funds 10% for other dividends (formerly 15%) Interest income: 10% (formerly 15%). A reduced 4.9% and 0% withholding tax rate is established for financial institutions and pension funds, respectively Capital gains: 10% (formerly 25% rate) irrespective of shareholding percentage (formerly, only if the seller holds direct or indirectly at least a 25% stake) Enhancement of the reorganization provision allowing for tax-free share for share transactions, with roll-over in tax basis An anti-abuse clause in the form of a PPT which is aligned with the one set out by the MLI This Alert summarizes the main changes to the Convention arising from the Protocol. Detailed discussion Dividends (Article 10) In the case of dividends, the Protocol introduces a full exemption at source on dividends paid to a resident that owns more than 10% of equity interest in the distributing entity and the dividend recipient entity qualifies as a beneficial owner of the dividend. 4 There is also a dividend exemption applicable to payments to a qualified pension fund. In contrast, the lowest withholding tax rate provided by the Convention is 5%. The Protocol also added a definition of pension fund in Article 3 of the Convention (Definitions). The Protocol also reduces the general withholding tax rate from 15% to 10%. In practice, for dividends paid by Mexican entities, this reduction does not represent any real benefit as the withholding tax rate on dividends is currently 10% under local legislation. Interest (Article 11) With respect to interest, the Protocol reduces the general withholding tax rate, including the rate applicable to intercompany interest, from 15% to 10%. Furthermore, the Protocol also reduces the withholding tax rate on interest paid to financial institutions from 10% to 4.9%. This rate is applicable to interest paid to financial institutions, including investment and savings banks, insurance companies, as well as interest coming from bonds and other credit titles that are regularly and substantially traded on a recognized stock exchange. The 4.9% is generally available under Mexican domestic legislation on interest paid to a financial institution resident in any treaty jurisdiction. Finally, the Protocol grants an exemption on interest payments made to pension funds, the Contracting States, their political subdivisions, local entities, or Central Banks, as long as certain requirements are met. Royalties (Article 12) No changes were introduced in relation to royalty payments (i.e., 10% withholding tax rate). However, the Protocol does clarify that income derived from technical assistance should be characterized as either business profits (Article 7) or professional service fees (Article 14) and not as a royalty. Capital Gains (Article 13) The Protocol reduces the capital gains tax rate to 10% on the sale of shares. In contrast the domestic rate in Mexico is 25% on gross proceeds or 35% on net gains while the domestic rate in Spain generally amounts to 25% on net gains. The Convention had previously provided for a rate of 25% on capital gains. The 10% capital gains rate is consistent with some of Mexico s other recently amended treaties such as that with the Netherlands. Under the current treaty, capital gains derived by a resident of a Contracting State from the transfer of shares (or comparable interest) of an entity resident of the other Contracting State, may be taxed in that other Contracting State if the recipient holds a participation, directly or indirectly, of at least 25% in the capital of that entity. The new Protocol eliminates the reference to the shareholding percentage and subjects to tax (10%) any transfer of shares of an entity resident in a Contracting State.

3 Global Tax Alert Americas Tax Center 3 The Protocol also establishes that capital gains derived from the transfer of shares of an entity whose value is derived, directly or indirectly, more than 50% from real estate assets located in one Contracting State may be taxed in such Contracting State. 5 The Protocol clarifies that real estate assets used in industrial, commercial, agricultural or professional activities will not be included for these purposes. No capital gains tax will apply to the disposal of shares by financial institutions, insurance institutions and pension funds. Furthermore, the transfer of shares that are regularly traded on a stock exchange will not be subject to tax unless it derives from the transfer of shares of a Spanish real estate investment trust (the so-called, SOCIMI). In addition, the Protocol modifies the reorganization clause contained in the Convention, whereby it allows for a group to carry out a tax-free internal reorganization with a roll-over of tax basis for future transfers, so long as certain requirements are met. Hydrocarbons (Article 22) The Protocol introduces a new article in connection with hydrocarbons. This new clause sets forth that a permanent establishment (PE) will be created in Mexico if certain business activities related to hydrocarbons are carried out in Mexico for a period or periods that exceed 30 days in a 12-month period. This article also addresses the taxation of foreign resident individuals under these types of projects. When computing the abovementioned 30 day-period, business activities carried out by associated enterprises should also be considered provided that said activities are identical or substantially similar to those carried out by the associated enterprise and form part of the same project. For these purposes, the concept of associated enterprises will have the meaning given by the domestic legislation of each Contracting State. This new clause reflects the Mexican domestic threshold for a PE included in the Hydrocarbons Law which was established in recent years. Dual-Residence (paragraph 3 of Article 4) The Protocol also addresses the dual-residence issue, under which an entity may qualify as a resident in both Mexico and Spain. The decision would generally be made based on the place of effective management of the enterprise. However, in the case of dual residence, the Protocol provides that the determination should be made based on mutual agreement considering certain facts, such as the place in which the counsel or senior executives carry out their habitual activities. Most Favored Nation (Paragraph 6 of the protocol to the Convention) The Most Favored Nation (MFN) provision of the Convention is replaced with a new provision applicable for withholding tax on interest and royalty payments if Mexico enters into a new convention with another Organisation for Economic Cooperation and Development (OECD) member or from the European Union with lower rates. Information Exchange and Assistance in Collection (Articles 27 and 28) The article pertaining to Exchange of Information has been replaced for consistency with recent developments. Furthermore, a new article addressing Assistance in Collection has been added to the Convention. Anti-abuse PPT clause (Paragraph 1, subparagraph b of the protocol to the Convention) In general terms, this rule reflects the PPT rules introduced by the OECD in its BEPS Project, in the Action 6 Final Report, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, with some language modifications. In general terms, this new rule sets forth that the benefits granted under the Convention will not be granted when it is reasonable to conclude, taking into consideration all relevant facts and circumstances, that an agreement or transaction that directly generated the right to receive such benefit, has as one if its principal purposes to obtain the benefits of the Convention, except when it is determined that the granting of these benefits under these circumstances is in accordance with the objective and purpose of the Convention. Also inspired by the Action 6 Final Report, the Protocol modifies the preamble to the convention, where it is clearly stated that the purpose of the Convention is to eliminate double taxation with respect to taxes on income and on capital, without creating opportunities for non-taxation through tax evasion or avoidance (including through treatyshopping arrangements aimed at obtaining reliefs provided in the convention for the indirect benefit of residents of third states).

4 4 Global Tax Alert Americas Tax Center The inclusion of these anti-abuse rules may limit the applicability of some of the provisions of the Convention and its Protocol for groups using either Contracting State as an intermediary holding company. Structures and substance should be evaluated for investors into one Contracting State from the other Contracting State to evaluate compliance with this provision before the provisions of the Protocol go into effect. The MLI In addition to the above, on 7 June 2017 Mexico and Spain (along with 66 other jurisdictions) signed the MLI. For this purpose, Mexico notified that all of its treaties should be covered by the MLI (including those that are still not in force, such as the new treaty with Spain resulting from modifications to the Protocol). Spain also notified that most of its treaties (86 out of 93) should be covered by the MLI, including the new treaty with Mexico resulting from the Protocol. Within the MLI s most important measures, the PPT rule and the modification of the preamble stands out, which have been included in this Protocol. Likewise, on 7 June 2017 Mexico and Spain notified a (provisional) matching position with respect to the following articles of the MLI: Article 10 Anti-abuse rule for PEs situated in third jurisdictions Article 12 Artificial avoidance of PE status through commissionaire arrangements and similar strategies Article 13 Artificial avoidance of PE status through specific activity exemptions (including the anti-fragmentation rule) Although, it is expected that the changes introduced by the MLI to the bilateral treaties will take some time to take effect, there may be a period where the Convention is in force before the MLI, which could result in additional changes to the interpretation and application of the Convention. However, as part of the signing of the MLI, Mexico and Spain disclosed that their treaty already contains the PPT clause that fulfills the standards set forth by the OECD under Action 6 of the BEPS project. Furthermore, as noted, it is expected that the Protocol will be in effect as from 27 September 2017 (for withholding tax matters), earlier than the MLI. Implications The new Protocol reflects the desire of both Mexico and Spain to further develop their economic relationship and to enhance their cooperation in tax matters. This is achieved by reducing the withholding taxes on dividends, interest and capital gain as well by introducing new rules to improve the exchange of information and assistance on the collection of taxes between both countries. Accordingly, multinational companies investing in Mexico through Spain, or vice versa, should evaluate the current structure in line with the changes coming first through the Protocol and also with the MLI. The PPT provides a new level of treaty shopping considerations. Endnotes 1. Base Erosion and Profit Shifting. 2. Mexico signs Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, dated 17 July Spain signs Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, dated 15 June Once the MLI becomes effective between the two countries, a 365-day holding period requirement may be additionally imposed to apply the reduced rate, according to the provisional positions notified by both countries on 7 June Once the MLI becomes effective between the two countries, the 50% threshold may be considered to be met at any time during the 365-day period preceding the alienation, according to the provisional positions notified by both countries on 7 June 2017.

5 Global Tax Alert Americas Tax Center 5 For additional information with respect to this Alert, please contact the following: Mancera, S.C., Mexico City Koen Vant Hek Koot, ITS Leader koen.van-t-hek@mx.ey.com Terri Grosselin terri.grosselin@ey.com Mariana Covarrubias mariana.covarrubias@mx.ey.com Javier Díaz de León javier.diazdeleon@mx.ey.com Estela Miranda estela.miranda@mx.ey.com Raúl Moreno raul.moreno@mx.ey.com José Pizarro Suarez jose.pizarro@mx.ey.com Abril Rodríguez abril.rodriguez@mx.ey.com Alejandro Polanco alejandro.polanco@mx.ey.com Lourdes Libreros lourdes.libreros@mx.ey.com David F Dominguez david.f.dominguez.palacio@mx.ey.com Mancera, S.C., San Pedro Garza García José A Olmedo jose.olmedo@mx.ey.com Alejandra Sánchez alejandra.sanchez@mx.ey.com Ernst & Young Abogados, Madrid Laura Ezquerra laura.ezquerramartin@es.ey.com Ernst & Young LLP, Spanish Tax Desk, New York José Antonio Bustos joseantonio.bustos@ey.com

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