November 21, 2016 Mexican 2017 Budget approved with tax package The tax package establishes new incentives and new rules for service fee payments, and makes significant changes to the value added tax (VAT). Specifically, the tax package allows taxpayers to elect how to treat VAT paid to suppliers during the pre-operating period. Because taxpayers may elect to request a refund of the pre-operating period VAT on a monthly basis from the tax authorities, taxpayers should implement systems to allow them to create the information that is needed to request a VAT refund in a very short period. Mexico's budget for 2017 has been approved by the two houses of Congress, with modifications to the original proposal, and now awaits signature by President Enrique Peña Nieto. The approved budget includes limited amendments to the primary federal taxes (i.e., income tax and value added tax (VAT)) and the federal tax code (the tax package). Many of the changes in this tax package relate to compliance, such as the requirement to provide additional support for sub-contracted services and administrative rules related to electronic invoices. The tax package also amended the income tax and VAT laws to require additional compliance and sharing of information. The requirement to share information is broadly worded and applies to sub-contracted labor services, which could be with third parties or related parties. The change to the VAT for companies during the pre-operating period also could significantly affect taxpayers. Further, the tax package modified the income tax law to include new depreciation rates for certain assets, address compliance issues related to not-for-profit entities and provide incentives for certain industries. Payments for service fees The tax package includes rules related to the deduction of fees for service companies, as well as the VAT credit on these services. The tax package imposes additional compliance and reporting obligations on taxpayers that sub-contract labor services to ensure that the taxes for the labor services are paid. Although the tax package appears to provide some clarity on issues related to payments made for outsourcing arrangements, the tax package still specifically references outsourcing arrangements under the Federal Labor Law (FLL). Based on this wording with reference to the FLL, taxpayers need to make sure that they comply with the FLL's rules for outsourcing arrangements. That is, if an (intercompany) outsourcing arrangement does not comply with Article 15-A of the FLL, the relationship may be deemed to be a labor relationship, rather than a services arrangement, and VAT may not be recoverable for the contractor and other adverse income tax and labor law consequences may occur. For income tax purposes, the tax package requires service companies to provide certain information to operating companies. Specifically, the service company must provide copies of the: (1) electronic tax invoices showing the salary payments for the workers who are performing the subcontracted services; (2) the receipts and tax returns filed for taxes withheld from the salaries of the employees performing the services; and (3) the employer payroll and social security tax contributions. The operating company needs this information to deduct amounts paid for subcontracted labor and the service companies are obligated to provide this information. For VAT, in order for the operating company to credit the VAT paid for services under a labor subcontracting arrangement, the tax package requires the operating company to obtain documentation to show that the service company is declaring and remitting the VAT collected to the tax authorities. Specifically, the service company must provide a simple copy of the tax return, receipt of VAT payment and other information provided to the tax authorities to show the amount of VAT reported and paid. As with the income tax law, the VAT rules also refer to the FLL, so arrangements between service companies and operating companies must meet the requirements of the FLL. Income tax amendments Income recognition for hydrocarbon industry The tax package modifies the income tax law to clarify the income recognition rules for companies under new hydrocarbon agreements. The tax package provides that the receipt of in-kind payments under these agreements should not be recognized as income, but rather income is recognized when the product is sold. Because there is no pick-up of income on the receipt of the in-kind payments, there is also no cost-of-sales deduction when the product is sold. Depreciation rates Regarding depreciation rates, the tax package adds bicycles and electric bikes as a new category of assets for depreciation at a 25% annual rate. In addition, the tax package adds a separate category for hydrocarbon-related infrastructure with an annual depreciation rate of 10%. This category of depreciation includes: "equipment used in the transport of electricity; fixed infrastructure for the transportation, storage and processing of hydrocarbons; platforms and vessels for drilling and vessels for processing and storing hydrocarbons." In an effort to promote renewable energy, the tax package increases the deduction limit for energy efficient automobiles (e.g., electric or battery- powered vehicles) from MxP$175,000, the limit for other automobiles, to MxP$250,000. Not-for-profit entities authorized to receive donations The tax package modifies the rules for not-for-profit entities to address compliance issues and the treatment of an entity if compliance with the rules is not maintained. The tax package adds a new requirement for corporate governance and establishes options for compliance certification for these entities, as well as other administrative compliance requirements. Small taxpayers The tax package allows small corporate entities owned by individuals to elect to be taxed on a cash basis. Incentives The tax package includes a research and development credit. Taxpayers may claim a credit against the income tax liability equal to 30% of the qualified investments and expenses for technological research and development. If the credit is larger than the tax liability, it may be carried forward for up to 10 years. Taxpayers calculate the credit based on the incremental costs and investments made in the current year as compared to the average spent in the prior three tax years. Furthermore, the tax package requires the establishment of an inter-institutional committee to issue guidelines as to the qualified types of investments. For purposes of this incentive, investments and expenses include those made in Mexico that are designated directly and exclusively for the execution of projects that are for the development of products, materials or production processes that represent a scientific or technological advance. In addition to the research and development credit, the tax package establishes tax incentives in the form of tax credits for investments or contributions to projects in areas such as the performing arts, highly specialized sports and high performance athletics, and public charging stations for electric vehicles. Like the rules for the research and development credit, the tax package requires the establishment of a committee to determine the types of expenditures that qualify for tax credits. Additional VAT amendments In addition to the new rules for service company payments, the tax package includes changes to the treatment of VAT credits during the pre-operating period, clarifies the treatment of VAT on certain imports and expands the list of services that qualify for a 0% VAT rate when exported. VAT during pre-operating period The tax package includes changes to the rules related to VAT credits generated during the pre-operating period. The final tax package is a slight improvement over the original proposed tax package, which would have denied VAT credits until operations begin. As described later, the new rules allow taxpayers to elect how to treat VAT paid to suppliers during the pre-operating period. As background, Mexico's VAT system generally allows a credit for VAT paid to suppliers for goods and services that are strictly necessary business expenses related to VAT taxable activities, including activities, such as exports, that are subject to a 0% VAT rate. VAT paid to suppliers related to activities that are exempt from VAT is not creditable. The current system allows companies in a pre-operating period to estimate the eventual activities (proportion of VAT-taxable activities versus VAT-exempt activities) in determining the VAT credits during the pre-operating period. As such, if a plant is being constructed and that plant will produce goods subject to VAT on sale, the VAT paid during the construction of the plant will generally be creditable. If there is an expectation that the plant will also be used for exempt activities, an allocation should be made between the taxable activities and the exempt activities. VAT favorable balances (i.e., VAT paid to suppliers in excess of VAT collected from customers) can then be requested from the tax authorities, as needed. Under the tax package, taxpayers in a pre-operating period will be required to elect how to treat the VAT during the pre-operating period. In general, the election for VAT during the construction period consists of either: 1. Take the VAT credit once operations begin. VAT credits will be accumulated and adjusted for inflation from the time paid until the credit is allowed. Once operations begin and the credit for the pre-operating VAT is taken, the taxpayer can recover the VAT either through credits or refund. 2. Request a refund of the pre-operating period VAT on a monthly basis from the tax authorities. The VAT refund can be requested in the month following the month in which the VAT is incurred. In this case, the taxpayer requesting the refund will have to provide documentation to support the taxpayer's projected activities, including contracts, permits, licenses, plans, etc. In addition, the taxpayer will have to provide documentation to support the nature of the activities to be performed and the projected ratio of taxable versus non-taxable activities; how the pre-operating expenses are being financed; and the estimated date to commence operations. This election specifically states that the taxpayer may file a refund request the month following the month in which the expenditures and related VAT are incurred. As such, taxpayers must have systems in place to be able to create the information that is needed to request a VAT refund in a very short period. Many taxpayers currently take several months to compile the information needed for a refund request. Detailed electronic information, including details of the invoices making up the creditable VAT and support for the activities of the company, must be available. Because most of this information is now filed electronically, taxpayers must be aware of the electronic information that has been reported to the tax authorities. In both cases, estimates of taxable (including at 0% rate) versus non-taxable activities must be made and eventually compared to the actual activities of the taxpayer. To the extent that there are differences between the estimate and actual, adjustments must be made. For purposes of this rule, the pre-operating period is defined as the period in which the taxpayer incurs expenses and makes investments before the initiation of the sale of goods, rendering of services, or providing of temporary use or enjoyment of goods. For extractive industries, the pre-operating period is the exploration for the identification and quantification of new deposits that may be exploited. Furthermore, the tax package provides that the pre-operating period is a maximum of one year from the time of the first refund request, unless the taxpayer provides evidence to the tax authorities that the pre-operating period should last longer than the one-year period. In addition to the rules related to the elections and the pre-operating period, the tax package provides that, to the extent the taxpayer does not initiate operations within the 12-month period or the extended period estimated by the taxpayer, the VAT credits taken during the pre-operating period will have to be returned to the tax authorities, including interest and adjusted for inflation. There are certain issues not clearly addressed in the new law, such as what happens if the refund request is not made in the month following the month in which the VAT is incurred. It is also unclear whether the VAT election must be made for the entire period or whether the taxpayer can make the election on a month-to-month basis. Imports For imports, the tax package clarifies that the lease of assets that are delivered outside of Mexico is not subject to VAT, if VAT is paid on the import of the assets into Mexico. Furthermore, VAT is not deemed to be paid on import if the payment is in the form of a tax credit, such as with a VAT credit allowed against VAT on certain temporary imports. In addition, the tax package clarifies that the self-assessed VAT on imported services is triggered when the service is paid. The tax package also clarifies the value to be considered for certain imported activities, such as leasing. Exported services The tax package expands the types of services that qualify for a 0% VAT rate when exported to include certain information technology services, such as: — Development, integration and maintenance of information applications or computational systems The tax package contains specific rules for the qualification of these services for the 0% rate. To qualify for the 0% rate: (1) the service provider must provide details about the customer and payments; (2) all of the infrastructure, human resources and materials must be located in Mexico; and (3) the IP address and internet service provider of the service provider must be in Mexico, while that of the customer must be outside of Mexico. The tax package also indicates certain instances in which the service will not be considered exported, e.g., certain virtual private networks that allow international connections and if the services are provided for assets located in Mexico. Federal Tax Code The tax package modified the Federal Tax Code to clarify certain administrative rules, including those related to electronic audits and field audits. In addition, the tax package added a new requirement that applies if an invoice is cancelled. Under that requirement, the recipient of the invoice (the customer) must agree and approve that the invoice is cancelled. ———————————————
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