Dear Clients and Friends:
25 years ago, a provision was included in the Income Tax Law (“IT Law”) which permits tax authorities to recharacterize as dividends the interest paid by a taxpayer, when it is derived from “back-to-back credits”.
One of the effects of this recharacterization is the rejection of the deduction taken for the payment of interest, because dividends are non-deductible for IT purposes. Also, when an entity distributes dividends it must pay IT, except when such dividends are paid from the Net Tax Profit Account (“CUFIN” for its Spanish acronym), however, in our experience, in the case of a recharacterization of interest to dividends because of back-to-back credits, the tax authorities interpret that it should not be permitted that such dividends are paid from the CUFIN, even if there is a favorable balance in such account, which implies having to cover IT over the amount of the dividends at an effective tax rate of 42.86%.
Up until 2021, in order for the tax authorities to be able to make a recharacterization of interest to dividends because of the existence of “back-to-back credits”, several requirements had to be met, such as the fact that the financing had to be granted between related parties, and also their necessarily had to exist two acts in which one person provided cash, goods or services to another, and this last person, in turn, provided cash, goods or services to the person first mentioned or to one of its related parties (among other cases of back-to-back credits).
However, even though Article 11 of the IT Law still contains the aforementioned characteristics of what constitutes a “back-to-back credit”, for 2022 a last paragraph was added to this Article which states: “The treatment of back-to-back credits will also be given to those financing operations different from the ones previously referred in this Article from which interest derive that is payable by entities or permanent establishments of foreign residents, when such operations lack a business reason”.
This addition to Article 11, because of the way it is written, implies that any financing transaction, whether or not it occurs between related parties, and regardless of whether such operation is constituted by only one act of providing cash (instead of two acts), may be considered as a back-to-back credit if a tax authority determines that the operation lacks a business reason, which would lead to a recharacterization of interest to dividends with the previously described tax consequences.
It is because of this reason that as of 2022, any financing received by an entity or a permanent establishment of a foreign resident in Mexico, must be supported with a business reason to avoid adverse tax consequences, which on occasion can result complex taking into account that the concept of a “business reason” is not clearly defined in the tax laws, as they only contain presumptions that the authorities can part from to consider that a business reason has not existed, however these presumptions can be refuted and disproven by the taxpayer with the adequate evidence, which is why it is necessary to always have the appropriate support and arguments with which the person that receives the financing can prove the existence of a business reason in said operation.
Should you have any questions related to the foregoing, please do not hesitate to reach out to your usual contact at the Firm.
Tax Consultancy & Litigation
Fernando Holguín
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Arturo Bañuelos
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Felipe Mendoza
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Edmundo Hernández
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Franco Herrera
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