February 26 2010
In January 2008 a flat-rate business tax came into force in Mexico. This tax is charged on the income obtained from the alienation of goods, the provision of temporary use or enjoyment of assets and the provision of independent services. It has been criticized by many business commentators for allowing a bare minimum of deductions.
The flat-rate business tax does not permit the deduction of many significant expenses that are necessary to develop taxable activities (eg, salaries, interest, investments made before the tax was introduced and royalty payments between related parties). This, as well as the different treatment of such expenses, led many companies to challenge the constitutionality of the tax on the grounds that it violated the principles of legality and vertical and horizontal equity.
The claims against the tax were joined for resolution by two federal district courts, which both ruled that the tax does not violate constitutional principles.
The two judgments were appealed to the Supreme Court which, after several hearings and much deliberation, upheld the lower courts' decision on February 9 2010.
Nature of the tax
The court stated that the tax is charged on the gross income obtained from the transfer of goods, the provision of independent services and the granting of temporary use or enjoyment of assets, and that for the purposes of the tax, 'income' refers to the price or payment in favour of the party that performed the activities in question. Therefore, the court held that the tax is not illegal, since the object and basis of the tax charge is defined in the relevant legislation.
Moreover, the court ruled that the tax does not violate the principle of vertical equity, even though it does not allow for the deduction of salaries, interest, investments made before its introduction or royalty payments between related parties. It based this finding on the fact that the flat-rate business tax - which is a tax levied on gross income - is not required to allow for deductions that are permissible for income tax purposes.
The court considered the treatment of royalty payments between related parties under the Flat-Rate Business Tax Law, as opposed to the treatment of payments between unrelated parties, and held that the difference in treatment does not violate the constitutional principle of horizontal equity. The prohibition against deductions in respect of royalty payments between related parties was held to be justified in light of the risk that related parties might conduct transactions without maintaining arm's-length conditions.
In addition to the general considerations regarding the limited set of allowable deductions, interest expenses presented an additional problem. If a sale included financing, interest was considered part of the sale price and taxed accordingly. Similarly, in the case of a party purchasing goods or services, the full amount was deemed the purchase price and could be deductible. Other financing transactions, such as loans, were not subject to tax; therefore, interest paid in such financing transactions was non-deductible.
Regarding this differentiated treatment of interest, the court ruled that it did not violate the horizontal equity principle, since interest arose from two different economic and legal transactions in terms of the relevant provisions of the law; therefore differentiated treatment could not violate this principle.
On the question of the non-deductibility of inventory and fixed assets acquired before the law entered into force, the court stated that the tax does not violate the principle of horizontal equity. It held that such investments are not legally equivalent to investments made since the law has been in force.
In addition, the ruling establishes that the modification to the mechanism for recovering asset tax paid over the preceding 10 years does not violate the constitutional principle that laws cannot apply retroactively to a person's detriment, as the right to reclaim such tax is conditional on having paid income tax in excess of annual asset tax.
The ruling potentially raises a new problem in respect of the right of foreign companies to credit flat-rate business tax paid in Mexico in order to avoid double taxation. Most double tax treaties to which Mexico is a signatory grant the right to credit income tax and similar taxes. However, this ruling specifies that flat-rate business tax is not a form of income tax. As a result, jurisdictions that have a double tax treaty with Mexico may need to review and revise their position on whether flat-rate business tax payments can be credited for treaty purposes.
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Christian R Natera