Mexican taxpayers are obliged to determine their taxable income and authorized deductions derived from related party transactions considering the prices that would have been used in comparable transactions with or between independent parties. This is, in Mexico the arm's length principle is recognized for tax purposes.
In the previous administration2, the transfer pricing department within Mexico's Tax Administration ("SAT" for its acronym in Spanish) had an important consolidation going from a mere documentation compliance matter to an strategic risk assessment tool for Multinational Companies ("MNEs").
The latter may be observed not only with the inclusion of new transfer pricing related provisions and obligations such as the local file, master file and country by country report, among others, but with the requirements regarding the economic substance and materiality that have been observed within tax audit procedures in the last years.
In connection with intercompany transactions, taxpayers have to demonstrate not only the compliance with the arm's length principle and with formal requirements such as having the transfer pricing contemporaneous documentation and have submitted the diverse informative tax returns to which they are obliged, but to demonstrate the economic substance and materiality of the transactions carried out with its related parties, both domestic and foreign.
There are certain related party transactions that the tax authorities have been paying special attention to, requiring taxpayers to demonstrate that such transactions have economic substance. In general, these transactions include payment for services rendered abroad, royalty payments and interest payments. Moreover, there are transactions carried out with unrelated parties such as advertising and promotion which also require this kind of documentation.
Specifically regarding the payment for services rendered abroad, elements such as the following have to be taken into consideration to analyze the economic substance of the transaction: i) demonstrate the economic benefit of the transaction for the Mexican taxpayer (either by demonstrating an increase in revenue of by an increase in profitability), ii) demonstrate the capabilities of the service provider, iii) analyze and prove the non-duplicity with other services received by the Mexican taxpayer or with activities performed by the Mexican company, and iii) demonstrate that the services were effectively rendered.
Recently the Mexican tax court has determined that in connection with services transactions, in general, the economic substance is proven when the economic position of the taxpayer is significantly altered by means of entering into the analyzed transaction. This is, the presence of economic substance in a transaction should be understood as the reasonable potential to obtain profits or the possibility of sustaining a loss in circumstances beyond the control of the taxpayer.
For purposes of demonstrating the economic substance of transactions, the Mexican tax court has suggested a list of evidentiary documentation elements. Such elements include i) analysis of the need to receive the services, ii) documentation of the negotiation process previous to contracting the services, iii) documentation to prove the follow up on the agreements reached by the parties, iv) documentation that demonstrates the realization of the services and progress reports, v) deliverables, vi) advisors' opinions related with the analysis of the need to contract the services, vii) correspondence between provider and receiver and with advisors related with the services transaction, viii) demonstrate financial and accounting matters of the transaction such as profitability of the expense or investment, the rate of return, among others.
On the other hand, when dealing with advertising and promotion expenses, in general, the identification of value creation and DEMPE activities (development, enhancement, maintenance, protection and exploitation of intangibles) of the parties involved in the transaction should be taken into consideration for purposes of determining the economic substance of the transaction.
It should be analyzed whether if such advertising and promotion expenses are related with the intangibles owned by a foreign based related party, if the advertising and promotion expenses are related with the sale activity performed by the Mexican entity, among diverse other elements to identify value creation and DEMPE activities for each party involved in the transaction and therefore, determine the economic substance of the transaction.
When dealing with advertising and promotion expenses transactions in conjunction with royalty payments, the DEMPE activities analysis becomes even more relevant and additional elements such as to prove which intangibles are related with the royalty payments, prove that the intangibles for which a royalty payment is made provide an economic benefit for the Mexican taxpayer, among diverse other elements, should be taken into consideration.
This analysis is crucial for income tax deductibility purposes since the lack of it may jeopardize the deductibility of royalties and/or advertising and promotion expenses, even though the latter might be carried out with non-related parties.
Another intercompany transaction that has been subject to economic substance analysis tests is the interest payments. The analysis or information usually requested in related with analyzing the need of the loan, analysis of the proceeds of the loan that gave rise to the interest payments, the cash flows of the incoming loan and interest expense, analysis, description and supporting documentation related with the use of the loan, among other elements.
As it may be observed and derived from our experience dealing with transfer pricing audit procedures, demonstrating the economic substance of related party transactions is a crucial matter when dealing with such controversies.
This is, nowadays related party transactions cannot be analyzed exclusively from an arm's length nature perspective, but a thorough economic substance analysis should be performed for income tax deductibility purposes.
This economic substance analysis for related party transactions certainly will become even more important in the following years, not only due to increasingly complex transfer pricing systems worldwide, but because of the digital transformation that the global economy is going through.
The specific characteristics of the digital economy businesses, has resulted in changes in tax laws worldwide in order to address digital economy matters which will certainly impact the way the MNEs structure their global operations. This, in turn will have an impact on transfer pricing matters giving more importance to economic substance tests within different jurisdictions.
- The authors wish to thank Ignacio Mosquera, Associate at Chevez Ruiz Zamarripa for his collaboration in this article.
- In Mexico, the government executive branch has a 6-year term. On December 1st, 2018, the president office started its term.