Mexico, as a flourishing economy, has attracted numerous foreign investors seeking lucrative investment opportunities. To ensure fair competition and safeguard its tax revenues, Mexico has established comprehensive legislation to regulate thin capitalization, specifically for corporations receiving loans from their overseas holdings
The Mexican government recognizes the importance of preventing excessive interest deductions that may diminish tax revenues. To address this concern, the Mexican Income Tax Law (MITL) clearly outlines regulations related to thin capitalization and interest expense deductions. These regulations are primarily governed by Article 28 of the MITL, supported by various corresponding resolutions and guidelines set forth by the tax authorities.
According to Mexican law, thin capitalization occurs when the debt-to-equity ratio of a Mexican corporation exceeds certain predetermined limits. In Mexico, both interest payments and the loan amount are subject to thin capitalization rules. However, it is crucial to note that these rules only apply to loans received from related parties or entities.
The specific thresholds set by Mexican law are as follows:
- General rule: For corporations, the debt-to-equity ratio must not exceed three to one (3:1).
- Financing entities: Financial institutions and certain non-financial entities engaged in lending activities must maintain a debt-to-equity ratio not exceeding ten to one (10:1).
If a Mexican corporation exceeds the prescribed debt-to-equity ratio, expenses arising from interest payments may not be fully deductible for tax purposes. In this scenario, Mexican tax law stipulates two courses of action that authorities can undertake:
- Debt recharacterization: Mexican tax authorities have the power to recharacterize an excessive loan as equity, resulting in a denial of interest deductions. The principal purpose behind this provision is to ensure that excessive debt does not exploit tax advantages.
- Back-to-back loans: Mexican thin capitalization regulations also tackle back-to-back loans, which refer to loans received by a Mexican corporation from a related party, where the corresponding lender has received funding from a third party. In such cases, the tax authorities have the authority to evaluate both sides of the transaction and potentially disallow any interest deductions.
The Mexican government, with its robust regulatory framework, ensures fair tax practices and prevents the erosion of tax bases by closely regulating thin capitalization. By establishing clear thresholds and consequences for violations, Mexico encourages responsible borrowing practices while ensuring that tax revenues are safeguarded. Foreign investors looking to invest in Mexico should be well aware of and adhere to these regulations to avoid any potential penalties and maintain a sound and compliant business environment.
Héctor Otero
hector.otero@gphlegal.mx
