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Fiscal reform and transfer pricing – An opportunity for Mexico

Simon Somohano, Deloitte, Mexico

Why is fiscal reform needed in Mexico?

To date, tax reforms have paid off and allowed Mexico to achieve an enviable level of macroeconomic and financial stability. However, according to the OECD, Mexico's public finances are facing increasing pressure from higher pensions, social expenditures, infrastructure spending needs, and an intense dependence on oil revenues. In this context, it is important to consolidate the improvements that have already been achieved, but it is also necessary to address deeper structural challenges facing key sectors.

Despite Mexico's good fiscal record, the OECD points out the following structural challenges the country must face: (i) improve its growth rate; (ii) find additional sources of income to reduce dependence on oil revenues, especially given the decrease in oil reserves; (iii) improve the efficiency and effectiveness of public spending; and (iv) improve accountability and control subnational spending.

Tax collection in Mexico is the lowest compared to the average in Latin America if income from the rights to hydrocarbon production is not taken into account, the OECD said in 2010. Tax collection relies heavily on indirect taxes, and in particular on taxes from the production of hydrocarbons. The dominant role of indirect taxation, combined with the relatively small portion of tax revenues generated by individual income tax payments, contribute to reduce the progressivity of the tax system.

The tax burden in Mexico (income taxes as a percentage of GDP) has increased slightly over the last two decades, in comparison with other OECD member countries, where it has remained relatively stable. However, this upward trend is mainly derived from the rights over production of hydrocarbons. If the income from those rights is removed from total tax collection, tax revenues show only a slight increase between 1990 and 2010. This upward trend of tax income is a common characteristic of Latin American countries, and reflects mostly favorable macroeconomic conditions, changes in tax regimes, and a strengthening of tax administrations. In this sense, the gap between tax and income in OECD member countries and Latin American countries has been declining, especially since the year 2000.

In general, the tax burden in Mexico was higher than the average in Latin America from 1990 to 2008, reaching its highest level at 20.9 percent in 2012. After a sharp decline of 3.5 percentage points in 2010, Mexican tax revenue began to show signs of recovery from the impact of the global economic crisis, although the level of recovery is below the regional average. However, if the rights over hydrocarbon production are not taken into account, the tax burden in the country reaches only 13.9 percent, well below the regional average.

Compared to other OECD countries, Mexico has the lowest level of tax revenues for the period 1990-2010 (with the exception of 1990 and 1991, after Turkey, and in 2009 after Chile), primarily due to narrow tax bases, high levels of informality, and weaker tax administrations.

Based on the above, it is not surprising that soon after President Enrique Peña Nieto's new administration took office at the end of 2012, it negotiated a successful cross-party pact that has broken the congressional gridlock that characterized Mexican politics over the previous 12 years. After allowing the enactment of labor and telecommunications reforms earlier this year, the pact is aimed now at two other major reforms that are desperately needed. First, an amendment to the constitution to allow private exploration and drilling in oil and gas fields would bring in foreign investment. Simultaneously, the fiscal reform would raise tax receipts in line with other OECD countries, and would also allow the government to stop taking advantage of the state-owned oil company, Pemex, to supplement insufficient tax revenue. If implemented properly, some analysts believe that the energy and fiscal reforms could add more than 1 percentage point to Mexico's annual GDP growth.

Why are changes to Mexico's transfer pricing legislation needed?

Mexico was the first country in Latin America to enact transfer pricing legislation almost 20 years ago, and transfer pricing legislation and practice in Latin America have been modeled to some extent on the Mexican experience; however, the Mexican legislation is unlikely to provide a role model for any country. To its credit, transfer pricing legislation in Mexico was bold enough to embrace enthusiastically the arm's length principle years before any hints of serious discussions on transfer pricing took place in some developed countries, let alone emerging economies, showing a decisive intention to insert the country in the modern global trade and investing environment. Unfortunately, the Mexican transfer pricing legislation is also extremely limited in its guidance, incomplete, and sometimes even poorly written. Numerous miscellaneous rules, nonbinding criteria, and temporary decrees have been needed to clarify important aspects of the rules.

Even if the rules had been properly drafted, there are significant day-to-day challenges to proper implementation. The lack of publicly available information on local comparable transactions, the limitation of data that frequently complicates the application of reliable adjustments to achieve an acceptable level of comparability, and the interaction of transfer pricing regulations and practices with the general legal system are only a few examples of the challenges taxpayers, tax practitioners, and the tax authorities face. (For a further discussion on those challenges, see [Somohano, S. and Mesta, J. 'Latin America's long journey'] in 2011 Guide to the World' Leading Transfer Pricing Advisers. Legal Media Group/Euromoney.)

For these and other reasons, the Mexican transfer pricing regime now appears outdated. Over the past three years, the OECD has published an updated set of transfer pricing guidelines and produced several reports on tax base erosion, profit shifting, and supply chain restructures–putting transfer pricing at the center of the tax debate. By comparison, the last significant addition to Mexico's transfer pricing rules dates back to 2006, only a distant memory considering how much has changed in the global economy since then. New and more complex business practices have emerged, characterized by the increasing importance of intellectual property as a value driver and by constant developments in information and communication technologies.

The prospective tax reform provides a unique opportunity to achieve two important goals: (1) address the existing challenges, and (2) update the rules to provide an effective regulatory framework for multinational corporations operating in Mexico.

After reviewing proposals for a new transfer pricing regime prepared by some professional associations, the Transfer Pricing Committee of the Mexican Chartered Accountants Institute -- arguably the most influential professional body and advocacy group on transfer pricing matters in Mexico -- decided that a more radical and cutting-edge proposal was needed to revamp the existing legislation. Some of the proposals simply imply clarification of the formal aspects of the regulations. This article will not address those, but rather will discuss some of the more substance-based proposals.

The following are among the areas where immediate legislative action is required to guarantee the proper application of the arm's length standard and to provide legal certainty to taxpayers.

Self-initiated adjustments. The current regulations provide guidance only in relation to international tax treaties Mexico has entered into, in cases where the competent authorities of the treaty partner adjust the prices or amount of compensation of a taxpayer residing in that country and the Mexican tax authorities accept the adjustment. In those cases, the related party residing in Mexico may file a complementary return reflecting the adjustment. There is no guidance whatsoever regarding self-initiated adjustments when a taxpayer discovers after filing the annual tax return that its transfer prices are not arm's length. It is then no surprise that self-initiated adjustments aimed to comply with the arm's length principle that result in lower income or higher deductions for taxpayers are frequently considered a "red flag" by the tax authorities. It is thus necessary to introduce an amendment to the regulations to specifically allow taxpayers to amend their annual tax returns when based on the results of a transfer pricing analysis.

Intangible assets. Intellectual property has probably become the most precious asset for any global corporation. The use, transfer, and licensing of trade marks, trade names, patents, processes, software, and other high-value intangibles give rise to a large number of intercompany transactions, and are thus subject to local transfer pricing rules. Intangible assets have been attracting increasing attention from the tax authorities; however, the Mexican rules simply do not include a definition of intangible assets. Moreover, widely used valuation techniques for intangible assets, such as the income method or the relief from royalty method, are not formally recognized as valid methods to evaluate the pricing of intangible property, leading to either an inexact estimate of the true arm's length value or leaving taxpayers in legal limbo about the valuation method chosen. Guidance on cost sharing -- how to allocate income and costs from the joint development and exploitation of intangible assets -- is also nonexistent under the current rules, creating a competitive disadvantage for companies operating in knowledge-intensive industries. (In fact, domestic law prohibits the deduction of costs charged by a nonresident on an allocation basis.)

Financial Reporting Standards. One of the most illustrative examples of Mexico's out-of-date transfer pricing rules is the reference to the generally accepted accounting principles (GAAP), which were replaced in 2006 by a new local Financial Reporting Standard or NIF that is used by the vast majority of companies in Mexico. (Effective January 1st 2012, only publicly traded companies in Mexico are required to report their financial information under the IFRS. The Mexican Stock Exchange has about 140 listed companies.) At first glance, an easy fix would be to simply change references to the NIF standard; however, more complex situations lie ahead. Given the lack of publicly available information on local comparable transactions or companies, taxpayers, tax practitioners, and authorities have used information on foreign comparable transactions, which use different accounting standards, such as local GAAP or IFRS. While historically in Mexico it has been acknowledged that some relatively harmless differences between local GAAP standards exist (that is, between US GAAP and Mexican GAAP), more recent research suggests that the use of financial information prepared under different accounting standards in a transfer pricing analysis (particularly US GAAP and IFRS) may create significant comparability issues that are not eliminated through the application of traditional adjustments. This situation is compounded by the current rules that limit the application of adjustments to enhance comparability to the comparable transactions or companies only. From a practical and technical perspective, it is far easier and more accurate to convert or adjust financial data of one company (typically, the Mexican tested party) to a common standard than to a group of foreign companies. Granted, this issue would not necessarily be solved by enacting new legislation, but the tax reform provides an opportunity to introduce a more flexible approach to the application of comparability adjustments and guidelines on the use of financial data under different accounting standards.

Economic cycle. One important aspect of assessing comparability, especially when a transactional profit method is applied, is the business or life cycle of the product of the controlled transaction, as well as those of the comparable uncontrolled transactions. As the OECD transfer pricing guidelines point out, to obtain a complete understanding of the facts and circumstances surrounding the controlled transaction, it is generally useful to consider data from both the year under examination and prior years. Differences in business or product life cycles may have a material effect on transfer pricing conditions that must be assessed in determining comparability. The data from earlier years may show whether the independent company engaged in a comparable transaction was affected by comparable economic conditions in a comparable manner, or whether different conditions in an earlier year materially affected its price or profit so that it should not be used as a comparable. The usefulness of multiple-year data in the evaluation of such business or life cycles in a transfer pricing analysis is clearly undermined when the rules limit multiple-year data for the tested party (usually, the Mexican taxpayer). An amendment to this limitation that allows multiple-year data for both the tested party and the comparable uncontrolled transactions would bring the Mexican rules in line with the OECD Transfer Pricing Guidelines and international practice.

Over the past 18 years, the transfer pricing practice in Mexico has matured, with taxpayers and tax authorities engaging more frequently in discussions on the substance of the transactions under dispute (compliance with formal requirements would likely continue to be part of such disputes, although taxpayers are significantly more wary about such compliance). As disputes grow more complex, following the evolving pattern of global businesses and information and communication technologies, the need for clear and detailed rules that are fully consistent with international standards should also increase, if Mexico is to continue benefiting from global trade and investment flows to boost its GDP growth. The imminent and long-awaited fiscal reform will provide a unique opportunity to revamp the transfer pricing regulatory framework in Mexico.