Effective Funds Flow Strategies: Strategies to Achieve Efficient Cross-Border Payments from Mexico to the U.S., for Financial Institutions and Other Multinational Business

FEDERICO AGUILAR and NICOLAS JOSE MUNIZ (Ernst & Young)

U.S. multinational businesses having operations in Mexico generally ought to be able to reduce their overall effective tax rate, provided careful tax planning is performed beforehand.

For instance, tax benefits may be obtained by taking advantage of the incentives enacted by the Mexican domestic law in relation to withholding tax on cross-border interest payments. Other benefits can be derived by exploiting the differences between the manner in which a particular transaction is treated for tax purposes in different countries (i.e., tax arbitrage).

This article highlights some of these tax-planning strategies including the use of cross-border loans and various financial instruments, and discusses some of the more pertinent Mexican and U.S. tax implications derived from these transactions. The overall objective of these tax-planning strategies is the reduction of a U.S. multinational’s Mexican tax liability, while minimizing the amount of income subject to tax in the United States on a current basis.

Multinationals often establish an overseas finance company to reduce the tax base of their foreign operations by transferring such profits over to a low-tax jurisdiction. Many countries throughout the world have enacted anti-avoidance legislation aimed at preventing the shifting of profits out of their jurisdiction and into a tax haven, including Mexico, which implemented anti-tax haven legislation beginning 1997.

For example, it is not feasible from a tax standpoint to set up a Barbados offshore company to lend funds into Mexico, because Mexican tax authorities identify Barbados as a low tax jurisdiction. That is, interest payments made by a Mexican borrower to a Barbados entity will be subject to a 40 percent rate of withholding tax (as opposed to the general 15 percent rate of withholding tax on interest paid to banks).

Furthermore, there is a presumption that the interest paid is not at arm’s length and therefore, not deductible for income tax purposes unless the Mexican borrower has documentation indicating otherwise.

Notwithstanding, there are other alternatives for lending into Mexico in a tax efficient manner.

For instance, while many countries have debt-to-equity ratios designed to discourage the reduction of taxable income through deductible interest payments, Mexico is one of many Latin American countries (with the sole exception of Argentina) that has yet to enact any thin capitalization rules.1

The vast majority of countries in Latin America, including Mexico, impose rather high levels of withholding tax on most types of interest paid to nonresidents. This is in sharp contrast to many European nations where the rate of withholding tax on cross-border interest payments is typically zero.

The high level of withholding tax has historically been a concern to many U.S. entities, especially financial institutions, operating in the region. One may recall that under the U.S. foreign tax credit rules, interest subject to a rate of withholding tax that is 5 percent or greater falls under the so-called "high withholding tax interest" basket.

For the most part, it is harder to obtain a tax credit in the U.S. for withholding tax that falls under this basket than, say, the general limitation basket or financial services basket (at least for financial institutions). In the absence of any income tax treaty to protect U.S. investors (with the notable exception of the treaty between the U.S. and Mexico), large U.S. financial institutions have historically pressured various Latin American governments to amend their domestic laws to allow for a reduced rate of withholding tax.

Not surprisingly, over the past decade interest paid on loans granted by foreign financial institutions are subject to significantly reduced rates of withholding tax throughout Latin America, as is the case in Chile (4 percent), Venezuela (4.95 percent), Colombia (0 percent) and Peru (1 percent).

Mexico has similarly adopted tax legislation that reduces the rate of withholding tax on interest payments on loans granted by registered foreign banks or financial entities to 4.9 percent.

The reduction is granted provided the financial entity resides in a country that has a tax treaty in force with Mexico and is duly registered with the Central Bank.2 Likewise, Article 11 of the Mexico-United States Convention for the Avoidance of Double Taxation, which entered into force on January 1, 1994, stipulates a rate of withholding tax of 4.9 percent for interest paid on loans granted by banks on or after January 1, 1999.

Large U.S. financial institutions interested in lending funds to Mexican entities may be able to generate more business by offering loans at competitive rates as a direct result of the reduced interest withholding tax on interest paid to offshore banks located in a non-low tax jurisdictions.

A U.S. bank may, for example, capitalize an offshore financing company in Hungary, which, in turn, lends the funds to various Mexican companies.

The benefits derived by using an offshore finance entity include little or no tax on interest or other income (interest received by the Hungarian offshore entity may be subject to 3 percent income tax), and a reduced rate of interest withholding tax as discussed previously.

These benefits are not exclusive to Hungarian offshore companies. As a matter of fact, any foreign bank or registered financial institution should derive similar tax benefits provided it does not reside in a low-tax jurisdiction.

Another important fact to bear in mind is Mexico’s inflationary adjustment regime. From a Mexican tax point of view, one should closely monitor whether the loans obtained from the U.S. financial institution generate so-called inflationary gain subject to income tax. In other words, the liability booked on the part of the Mexican borrower at the time the loan is agreed upon may generate "phantom" income as a result of its diminished value over time.

Furthermore, there are some general requirements stipulated under Mexican Income Tax Law as to deductibility of interest paid. For instance, interest paid abroad may not be deducted unless the loan is used to generate income producing activity, or the taxpayer (as withholding agent) applies the proper rate of withholding tax and files information returns.

In addition, the portion of interest paid that exceeds applicable market rates will not be deemed to be at arm’s length pursuant to the transfer pricing rules under Article 64-A of the Mexican Income Tax Law, and will be treated as a non-deductible dividend.

One also needs to consider the application of U.S. Subpart F provisions by which a U.S. taxpayer may be required to include in its gross income certain types of undistributed income of a controlled foreign corporation (that is, the offshore company). This adverse effect may be somewhat diminished depending on the U.S. multinational’s overall foreign tax credit position.

For example, a U.S. company in an excess foreign tax credit position may, nevertheless, be able to credit its excess foreign taxes paid or accrued against low taxed foreign source interest income earned by its offshore financing entity. Moreover, interest income received by the offshore entity may be exempt from the application of Subpart F provisions as active financing income under Section 954(h)(9) of the Internal Revenue Code (IRC) and thus, may avoid being taxed on a current basis.

A U.S. financial entity may be able to reduce the overall tax liability of its Mexican operations through the use of a so-called "hybrid" financial instrument, which combines the features of both debt and equity.

The goal, in other words, is to have the instrument treated as debt in Mexico and as equity for U.S. tax purposes. A lower effective tax rate is achieved in Mexico since the interest payments arising from said instrument should be fully deductible for income tax purposes provided certain conditions are met, while for U.S. tax purposes the "interest" would be treated as dividend income.

Should the payments be treated as dividend income for U.S. foreign tax purposes, the U.S. financial institution may be able to credit not only the Mexican withholding tax on the payments made (direct tax), but also the underlying income tax paid by its Mexican subsidiary (indirect tax). By reducing its Mexican income tax without reducing its earnings and profits for U.S. tax purposes, the U.S. entity will increase the likelihood of crediting both its direct and indirect taxes paid or accrued in Mexico.

Particular care should be taken when dealing with these hybrid financial instruments, as there is no clear guidance under U.S. tax law as to whether a particular instrument constitutes debt or equity. IRC section 385 simply states that the Treasury Secretary is authorized to issue regulations that set forth factors to be considered when determining whether a particular interest in a corporation constitutes indebtedness (liability) or stock (equity), or in some cases part debt and part equity.3

The weight to be given any factor depends upon all the surrounding facts and circumstances; that is, no particular factor is conclusive in making the determination. Also, it is interesting to note that deductibility in the foreign jurisdiction is not a factor for consideration by the U.S. courts.

The IRC goes on to state that the characterization (at the time of the issuance) as to whether the instrument is debt or equity shall be binding on the issuer, but not on the Secretary.

Because of the scarcity of statutory or administrative guidance other than the list of factors mentioned above, a fair amount of litigation has arisen attempting to define more precisely what is meant by the terms "debt" and "equity." Recently, the U.S. Tax Court in Laidlaw Transportation, Inc. v. Commissioner, T.C. Memo 1998-232, analyzed the debt/equity factors in the context of certain advances made by a Dutch financing subsidiary of a Canadian parent company to its related U.S. operating subsidiaries.

Since the Tax Court ultimately decided that the advances were essentially equity, it is important to keep in mind that the U.S. tax authorities will not only consider debt-equity factors under IRC section 385 but also common law doctrines such as substance over form.

In addition to hybrid instruments, U.S. multinationals may be able to use derivatives in order to reduce the taxable income of its Mexican operations while also reducing any withholding tax on payments made by such entities. Specifically, the yield on a cross-border loan can be reduced by denominating the loan in a low-yield currency to minimize withholding tax, while hedging the foreign exchange risk. This strategy takes advantage of the fact that, for the most part, loans denominated in a so-called "stronger" currency (a currency whose value appreciates relative to another currency) bear a lower interest rate than loans denominated in a "weaker" currency.

For example, instead of entering into a local currency loan, which, in Mexico, may currently pay interest at a rate anywhere between 24 to 28 percent, the U.S. financial entity may enter into a yen-denominated loan with its wholly-owned Mexican subsidiary, which pays interest at a rate of 2 percent or lower. The overall objective is to reduce the amount of interest payments subject to withholding tax, relative to the amount of withholding tax liability that would have been incurred if the loan were denominated in the local currency.

The local entity, in turn, may simultaneously enter into a foreign currency swap with a local bank for the purpose of reducing its overall exposure to any foreign currency gain or loss.

Under Mexican tax law, the yen-denominated loan hedged with the foreign currency swap, would probably constitute an equity-based derivative financial transaction. By way of background, derivative financial transactions (operaciones derivadas financieras) are defined as transactions involving the use of commonly accepted financial instruments such as futures, options and swaps and are divided into two main categories.

Debt-based derivatives typically make reference to interest rates, debt securities, or the National Consumer Price Index, and the resulting payments are treated as deductible interest subject to withholding tax if paid to a non-resident.

On the other hand, equity-based derivatives are based on other securities, foreign exchange, commodities or any other indicator. Gains and losses generated from equity-based derivative financial operations and paid to nonresidents of Mexico will not be characterized as interest for Mexican income tax purposes and therefore, will not be subject to withholding tax to the extent the sale of the underlying securities generates Mexican-source income exempt from tax. In our example, the derivative should result in tax-exempt gain or loss, rather than deductible interest payments subject to a reduced 4.9 percent withholding tax.

In relation to the U.S.-source rules, to the extent that there is an "integration" between the loan and the corresponding hedge in terms of timing and amount of payments, no mismatch should occur between the interest paid by the local company (generally treated as foreign source) and any foreign exchange gain derived from the appreciation in value of the strong currency (U.S. source).

The planning ideas described above are designed to create present value benefits for U.S. multinational businesses conducting business in Mexico (either by lending directly to Mexican entities or establishing local subsidiaries). These benefits arise by creating an interest expense or similar deduction in the foreign jurisdiction while reducing or eliminating any current foreign or U.S. taxation of the interest or similar income.

As the Mexican income tax law continues to develop and begins to address increasingly complex matters, more challenges (and hopefully opportunities) should arise for U.S. financial entities to properly manage their Mexican operations in a more tax efficient manner.

Finally, given the complexities associated with implementing these transactions and the constant modifications made to the tax law in both countries, we strongly recommend that U.S. entities operating in Mexico consult with their local tax and legal advisers before entering into these or any other transactions.

1. Although Mexico has no formal thin capitalization rules, the Mexican government did enact the asset tax law (known in Spanish as Ley Del Impuesto al Activo) in 1989; the asset tax is designed to act as an alternative minimum tax although it is somewhat different from the alternative minimum tax system as implemented in the United States. Generally speaking, the tax is imposed on the value of certain assets of a business at a rate of 1.8 percent, and is applicable only if the resulting tax exceeds the tax levied on income in any given year. Under the U.S.-Mexico income tax treaty as well as for U.S. federal income tax purposes, the Mexican asset tax is not a creditable tax as it does not constitute a tax that is levied on income; that is, a U.S. taxpayer may not claim as a foreign tax credit any taxes paid in Mexico to the extent they are in the nature of a tax on assets. To help alleviate the tax burden that a U.S. entity may endure when conducting business in Mexico, the Mexican Congress modified the law to allow taxpayers to offset the asset tax with any income tax paid or accrued, therefore potentially increasing the amount of Mexican tax that can be credited for U.S. foreign tax credit purposes.

2. The Mexican Tax Reform Act of 1999 extended through December 31, 1999, the reduced 4.9 percent rate of withholding tax on interest payments made to financial institutions located in countries having a tax treaty in force with Mexico. It is not certain whether this provision will be extended beyond 1999.

3. Factors enumerated under IRC section 385 to be considered when making such a determination, and which may be included in said regulations, include: (1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money for adequate consideration, and to pay a fixed rate of interest; (2) whether the instrument is subordinated or preferred over any other indebtedness of the corporation; (3) the debt to equity ratio; (4) whether there is convertibility into the corporation’s stock; and (5) the relationship between stock holdings and debt in the corporation. o

Federico Aguilar is a Partner, International Tax Services, in the Mexico City offices of Ernst & Young. Nicolás José Muñiz is a Senior Manager of the U.S. Tax Desk at the same office.