In an increasingly globalized economy it is more common to find companies that have commenced economic activities in other countries; whether it is to increase their production, to reduce costs, to enter a specific market, or for tax benefits. To that end, companies have mainly decided to give loans to their affiliates instead of making capital contributions.
For this reason the Organization for Economic Co-operation and Development (OECD) [In Spanish: la Organización para la Cooperación y el Desarrollo Económico (OCDE)], saw for its member countries, as well as for the tax authorities in Mexico, the need to prevent excessive debt with their related parties abroad and their affiliates in the country. For that reason a series of rules were adopted that seek to limit the deduction of interest that is derived from loans granted to related parties abroad, deducting only the interest that is related to an acceptable level of indebtedness.
Application in Mexico
As we previously mentioned in the specific case of Mexico, the rules concerning thin capitalization were included in the Law on Income Tax [in Spanish: la Ley del Impuesto Sobre la Renta (LISR)] as of the 2005 tax year. This provision is currently in force in article 28 section XXVII of the 2016 Law on Income Tax; wherein it also establishes the procedure for determining the amount of debt that exceeds three times that of the shareholders’ equity.
Elements and case studies
The elements that must be considered for determining the amount of interest that is non-deductible are the following:
- 1. Interest: The yields obtained on any kind of loan. For the purposes of the Law on Income Tax, interest is considered; including rate fluctuations.
- 2. Debts: This refers to any currency amount that is unpaid.
- 3. Debts contracted by foreign related parties: Any currency amount that is unpaid with foreign related parties that may generate interest.
- 4. Average shareholders’ equity: This is determined by dividing the total shareholders’ equity at the beginning and end of the tax year by two.
The objective of the calculation is to recognize that the level of indebtedness with foreign related parties is regarded as an acceptable level, so that if necessary, the deductibility of interest generated by these debts would be adjusted.
The procedure that establishes the Law on Income Tax is the part that compares the average yearly balance of the debts that generate interest with triple the shareholders’ equity. To be able to determine the deduction limit of the interest paid to foreign related parties, it is important to point out that the same Law on Income Tax establishes that the Financial Reporting Standard [in Spanish: la Normas de Información Financiera (NIFC-11)] be applied for assessing the shareholders’ equity.
In order to illustrate the aforementioned, we provide the following case study: (View PDF)
In closing, we need to mention that the current calculation is a little complex, since it requires joining different elements for carrying out a comparison between the shareholders’ equity and the debts that generate interest; for the purposes of establishing that the level of indebtedness be reasonable; and in this manner adjust the deduction on the interest paid to foreign related parties. It is important to mention that the limit on three times that of the Shareholders’ equity can be increased in those cases in which taxpayers prove that the activity that is carried out requires greater leverage. Taxpayers must fulfill this
requirement and obtain approval from the tax authorities regarding Advance Pricing Agreements (APA).
The Law on Income Tax establishes that taxpayers who do not apply what is provided for in the Financial Reporting Standard in assessing Shareholders’ Equity must consider as Shareholders’ Equity the balance that they have in the fiscal accounts of Capital Contributions [in Spanish: Cuenta de Capital de Contribución (CUCA)], and the Net Taxable Income Account [in Spanish: Utilidad Fiscal Neta (CUFIN)]. This factor is also an option for those taxpayers that apply the Financial Reporting Standard.
It is important to mention that in the specific case of those taxpayers who are members of the financial system, as well as for those who are engaged in the creation, operation, and maintenance of strategic areas (activities that are reserved exclusively to the state, for example, exploration and extraction of hydrocarbons), their debts are not considered to be related to operations that are appropriate to their purpose for determining what exceeds the Shareholders’ Equity by three times.
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