Mexico Addresses “Earnings Stripping”

Mexico Addresses “Earnings Stripping”

January 01, 2006

Mexico is continuing to tinker with strict limits it imposed a year ago that were supposed to limit the ability of Mexican companies to deduct interest paid to related shareholders.

The limits — called “thin capitalization” rules — prevent Mexican companies from deducting interest paid to anyone to the extent the companies have debt-equity ratios greater than three to one.

The thin capitalization limits took effect on January 1, 2005, but have been a source of controversy since then because key details about how to apply them remain vague.  Suits are pending in the Mexican courts to have the limits declared unconstitutional.  President Vicente Fox issued a decree on October 21, 2005 relaxing the restrictions by allowing money borrowed from financial institutions and spent on productive investments not to be counted as debt.  Congress — at the request of the president — passed a new law in late November that broadens the exception. The new law, to be effective January 1, 2006, should permit a Mexican tax deduction for interest on most project financing notwithstanding the taxpayer’s debt-equity ratio.

Background

The Mexican thin capitalization limits deny interest deductions on that portion of a taxpayer’s debt that exceeds a 3-to-1 debt-equity ratio.

Equity for purposes of the ratio is probably shareholders’ equity as reported for financial statement purposes.

The taxpayer’s debt for the tax year is determined by taking the average of its debt on the last day of every month during the year.  However, the word “debt” is not defined, and it is unclear whether accrued liabilities and trade payables are to be counted in determining the debt-equity ratio.

There is a five-year transition period that may enable taxpayers to avoid having their interest deductions denied if they are able to reduce excess debt “proportionately in equal parts” over the five-year period.  It is unclear what the consequences are if the taxpayer reduces its excess debt more quickly than “proportionately in equal parts” over the five years.

The thin capitalization rules apply to all related-party loans and to third-party loans from creditors located in or outside of Mexico.  Under the law as originally enacted, third-party loans are exempted from the 3-to-1 debt-equity ceiling only if the borrower obtains a ruling from Mexican tax authorities that all of its inter-company transactions are reasonably priced under approved transfer pricing methods.

The Fox administration proposed legislative amendments to the thin capitalization rules throughout 2005, concerned that the rules would impede the long-term financing needs of Mexican infrastructure projects and manufacturing operations.  On October 21, 2005, the administration issued a decree that created an exception from interest deduction denial for debt incurred to finance qualifying projects.

The presidential decree allows debtors to exclude from their debt-equity ratios any financing obtained from the financial sector that can be allocated to the construction, operation or maintenance of productive infrastructure or the manufacturing of fixed assets.  To qualify, at least 80% of the loan must be used in the acquisition or construction of fixed assets, land or engineering projects.  There are some additional requirements that are designed to ensure that the financing is in the nature of a typical long-term infrastructure financing, one of which is the creditor must impose conditions on the borrower in order to conserve the borrower’s financial resources.  To qualify for the decree exception, the financing contracts must contain at least six of 16 specified creditor-friendly terms, such as a provision permitting the creditor to appoint a member of the borrower’s board of directors and a provision prohibiting the borrower from entering related-party transactions without creditor approval.  If existing loans are refinanced to comply with these requirements, then they can qualify for the exception from the thin capitalization rules provided by the decree.

At the same time that the decree was issued, several legislative proposals to change the thin capitalization rules were being considered.  On October 28, the lower house of the Mexican Congress approved a tax bill containing a broad exception from the thin capitalization rules.  The exception permitted the deduction of interest on third-party debt if it incorporated the restrictions on borrower behavior that are typically imposed by unrelated creditors.  The proposed legislation was more generous than the presidential decree because it did not limit the thin capitalization exception to infrastructure projects or to financing from the financial sector.

On November 17, the Mexican Senate unanimously adopted a modified version of the proposed thin capitalization exception, along with several other tax changes.  The tax bill — to be effective January 1, 2006 — is expected to be signed by the president.

New Exception

Under the new rules, Mexican companies with debt-equity ratios above 3-to-1 will be permitted to deduct the interest paid or accrued on qualifying loans from third-party lenders.  These qualifying loans are excluded from the calculation of the taxpayer’s debt for purposes of the debt-equity ratio.

The exemption applies to all financing from unrelated parties that restricts the borrower’s ability to do all of the following: sell fixed assets, reduce capital or issue new share capital, distribute dividends or profits, enter into new financing, and impede the lender’s rights under the financing agreement.

The new legislation also spares taxpayers with excess debt who cannot deduct all their interest payments from having to include the excess debt in computing inflationary income (defined as the inflation effect for the year on average liabilities), thus eliminating a double hit to those taxpayers.

Unfortunately the new legislation fails to clarify some aspects of the thin capitalization rules that are not well understood.  As originally enacted, the rules contained a five-year transition rule under which the interest expense on debt in excess of the 3:1 ratio does not become nondeductible unless the taxpayer’s debt-equity ratio remains excessive for the five years.  There is no penalty if the taxpayer is able to reduce excess debt “proportionately in equal parts” over the five years, but there is no guidance as to what this requires or whether a failure to reduce debt sufficiently in one year can be rectified by extra reductions in a subsequent year.

The new legislation also fails to clarify whether general trade payables and other accrued liabilities — for example, court-ordered damages — are “debt” for purposes of computing the debt-equity ratio.

Taxpayers can choose to apply the new tax legislation retroactively to January 1, 2005.

Meanwhile, a significant number of Mexican companies have taken legal action against the thin capitalization rules in general, going to the courts and filing “amparo” suits.

The courts have yet to rule, but there is a strong feeling among tax litigation experts that there are enough grounds for the courts to rule for the taxpayers.