International tax planning between Mexico and the U.S. in COVID times
2020 will be remembered as a year that brought multiple changes in several aspects of life. International taxation is one of them, specifically in the North American region. As a consequence of COVID, in the U.S., the CARES Act provided relief for a wide range of businesses and individuals to reduce the impact of taxes in day-to-day operations. Although such relief is visible for domestic businesses, the relief provided for international operations, whether inbound or outbound, is less palpable.
In another North American jurisdiction, Mexico, a new tax reform entered into force on January 2020 to update the international tax framework and implement several BEPS measures. Despite COVID, such jurisdiction did not implement any measures to reduce the impact of this crisis.
On top of these tax transformations, there is another factor to be considered: the newly signed USMCA trade agreement between the U.S., Canada and Mexico, which surely will increase the economic integration of the North American region by improving the use of regional parts and alleviating barriers to the commercial trade.
These changes are relevant for individuals and businesses with operations in both sides of the border. For American investors, these changes represent an opportunity to restructure their operations to diminish the impact of COVID in outbound operations. For foreign investors from the North American region, given the current economic environment, this situation represents a unique opportunity to carefully analyze the structuring of current operations to reduce the impact of taxation.
This article will be a first of a series of posts to address the multiple opportunities given the new tax framework during COVID times. In this part, we will discuss the opportunities that foreign investors from the USMCA countries, specifically from Mexico, have to reduce the impact of taxes in inbound operations.
I. The 2020 Mexico Tax Reform.
On 2020, a new tax reform entered into force in Mexico. Such tax reform implements several BEPS measures, such as a mandatory disclosure regime, provisions to prevent hybrid mismatches, among others. One of the most relevant provisions that greatly impacts inbound investments in the U.S. is the introduction of measures to counter the use of transparent entities in jurisdictions such as the U.S. Moreover, the tax reform also establishes that any jurisdiction that has a statutory tax rate less than 75% of the Mexican statutory tax rate (30%) is deemed as a low-taxed jurisdiction (for example the U.S.).
Based on the above, multiple investors with investments on the U.S. will have to pay taxes on Mexico for any income received from U.S. investments, disallowing any tax deferral on income at the U.S. subsidiary level. This greatly impacts traditional tax structures where the investments profits are kept at a U.S. subsidiary (taxed as a C-corp).
These concerns greatly impact the current design of tax structures among cross-border investments between Mexico and the U.S. and may further the search for a more favorable planning.
II. The CARES Act.
In the U.S., the CARES Act provided relief to businesses to alleviate the impact of the COVID crisis. Such benefits are also available to investors with inbound operations. For example, the limitation relaxation on net operation losses (NOL), which allows taxpayers to apply 100% of NOL generated during 2020 and two prior years with a carryback of 5 years. Although an increase in NOL may greatly impact U.S. businesses with foreign operations by reducing the section 250 deduction, such impact is not seen on inbound structures, where GILTI usually does not apply.
Other provision that greatly helps inbound tax structures is the reduction on the limitation deductibility of business interest expense. Under the CARES Act, business interest expense is increased to 50% (from 30% under the TCJA) of the Adjustable Taxable Income (ATI). In structures where the foreign investors have a subsidiary taxed as a C-corp, the benefit applies not only for 2020 but also for 2019. Given that interest is a concept that is greatly used in international tax planning among members of the same corporate group, this provision represents a tool that under proper circumstances can alleviate the COVID impact.
III. Planning opportunities.
For inbound investors in the North American Region, COVID presents singular tax opportunities. For example, to maximize the deductibility of the business interest expense, subject to BEAT limitations, a tax structure using Spain as a holding corporation would allow to greatly reduce the impact of taxes on income received in the U.S.
This structure is possible given the newly signed Protocol to the Income Tax Treaty between the U.S. and Spain (the “Treaty”). Under the new rules of the Protocol, dividends and interest received from U.S. subsidiaries are subject to a 0% withholding tax rate, if the Spanish company receiving the dividends owns 80% or more of the U.S. subsidiary. It must be noted that the Protocol provides with an important Limitation on Benefits (LOB) provision that may prevent some investors from using these benefits. However, if the requirements for article 17 of the amended Treaty are met, dividends and interest from U.S. sources are taxed at 0%.
Given the wide tax treaty network that Spain has with multiple LATAM jurisdictions and Mexico, this structure is ideal for inbound investors from these jurisdictions, specially to Mexican investors. Considering that Mexico and Spain have a very investor-friendly treaty that provides for a 0% withholding for dividends and exempts interest paid from Spain companies, the proposed structure provides palpable benefits for inbound investors.
Additionally, given the fact that the corporate tax rate in Spain is 25% (which is over the tax rate of 22.5% to be considered a low-taxed jurisdiction under Mexican rules), this structure prevents immediate taxation at the 30% tax rate on U.S. earnings in Mexico, avoiding any investment in the U.S. to be considered as an investment in a low-taxed jurisdiction.
The current economic environment presents a great opportunity for international tax planning. Specifically, for investors in the North American region, there are multiple factors that may allow them to diminish the impact of taxes in the day-to-day operations, and more importantly, can provide with a more sustainable structure in the long-term.