Mexico — Cross-Border Tax Rules

Countries enact territorial tax systems through so-called “participation exemptions,” which include full or partial exemptions for foreign-earned dividend or capital gains income (or both). Participation exemptions eliminate the additional domestic tax on foreign income by allowing companies to ignore—some or all—foreign income when calculating their taxable income. A pure territorial system fully exempts foreign-sourced dividends and capital gains income.

Companies based in countries with worldwide tax systems are at a competitive disadvantage because they face potentially higher levels of taxation than their competitors based in countries with territorial tax systems. Additionally, taxes on repatriated corporate income in a company’s home country increase complexity and discourage investment and production.

The territoriality of a tax system is measured by the degree to which a country exempts foreign-sourced income through dividend and capital gains exemptions.

Dividends Received Exemption

When a foreign subsidiary of a parent company earns income, it pays corporate income tax to the country in which it does business. After paying the tax, the subsidiary can either reinvest its profits into ongoing activities (by purchasing equipment or hiring more workers, for example) or it can distribute its profits back to the parent company in the form of dividends.

Under a worldwide tax system, the dividends received by a parent company are taxed again by the parent company’s home country, minus a tax credit for taxes already paid on that income. Under a pure territorial system, those dividends are exempt from taxation in the parent’s country.

Countries receive a score based on the level of dividend exemption they provide. Countries with no dividend exemption (worldwide tax systems) receive the worst score. Dividend exemptions that are conditional on a qualified holding regime that requires corporate restructuring have their score halved.

Branch or Subsidiary Capital Gains Exclusion

Another feature of an international tax system is its treatment of capital gains earned through foreign investments. When a parent company invests in a foreign subsidiary (i.e., purchases shares in a foreign subsidiary), it can realize a capital gain on that investment if it later divests the asset. A territorial tax system would exempt these gains from domestic taxation, as they are derived from overseas activity.

Taxing foreign-sourced capital gains income at domestic tax rates can discourage saving and investment.

Countries that exempt foreign-sourced capital gains from domestic taxation receive a better score on the ITCI.

Restrictions on Eligible Countries

An ideal territorial system would only concern itself with the profits earned within the home country’s borders. However, many countries have restrictions on their territorial systems that determine when a business’s dividends or capital gains received from foreign subsidiaries are exempt from domestic tax.

Some countries treat foreign corporate income differently depending on the country in which the foreign income was earned. For example, several countries restrict their territorial systems based on a “blacklist” of countries that do not follow certain requirements. Among EU countries, it is common to restrict the participation exemption to member states of the European Economic Area.

The eligibility rules create additional complexity for companies and are often established in an arbitrary manner.

Countries that have these restrictions on their territorial tax systems receive a worse score on the ITCI.

These taxes make investment more costly both for investors, who will receive a lower return on dividends, and for firms, that must pay a higher amount in interest or royalty payments to compensate for the cost of the withholding taxes. These taxes also reduce funds available for investment and production and increase the cost of capital.

Countries with higher withholding tax rates on dividends, interest, and royalties score worse in the ITCI. Dividends, interest, and royalties from these countries do not always face the same tax rate as when distributed to domestic shareholders. Tax treaties between countries either reduce or eliminate withholding taxes.

Anti-avoidance rules can have the effect of making countries with uncompetitive tax structures even less competitive, as these rules can add significant complexity.

Controlled Foreign Corporation (CFC) Rules

CFC rules are intended to prevent corporations from shifting their pretax profits from a high-tax country to a low-tax country by using highly mobile forms of income. CFC rules are generally applied in multiple steps. First, they determine whether a foreign subsidiary is deemed a “controlled foreign corporation” for tax purposes. Second, if a foreign entity is deemed “controlled,” there is an applicability test to determine whether the CFC rules apply—generally through an income test, a predefined minimum tax rate, or a black/white list for countries. Third, if both tests are passed, the CFC rules subject the foreign corporation’s passive income (rent, royalties, interest) and sometimes active income to the tax rate of the home country of the subsidiary’s parent corporation.

CFC rules vary widely among countries. The definition of what constitutes “control” is a somewhat arbitrary decision that often increases tax code complexity.

Each country’s score in this subcomponent is based on three aspects of CFC rules: 1) whether there are CFC rules, 2) whether CFC rules apply to passive income or all income, and 3) whether there are exemptions from the general CFC rules. Countries receive the best score if they do not have CFC rules. Countries with CFC rules that have exemptions or only apply to passive income or income associated with non-genuine arrangements receive a better score. Countries score the worst if they have CFC rules that apply to all income and have no exemptions.

Interest Deduction Limitations

Many countries limit the amount of interest expenses a multinational corporation, or one of its subsidiaries, can deduct for tax purposes. Low-tax countries create an incentive for companies to finance their investments with equity, while high-tax countries create an incentive for companies to finance investments with debt and use interest deductions to reduce their tax liabilities. To prevent businesses from lending money internally from entities in low-tax jurisdictions to entities in high-tax jurisdictions for tax purposes, most countries limit the amount companies can deduct in interest.

Interest deduction limitations can vary widely among countries, and there is much discretion available to governments in enforcing these laws. Some countries limit interest deductions by applying transfer pricing regulations to interest rates. Others apply what are called “thin capitalization rules,” which limit the amount of deductible interest. The two most common types used in practice are “safe harbor rules” and “earnings stripping rules.”

Safe harbor rules restrict the amount of debt for which interest is tax-deductible by defining a debt-to-equity ratio. Interest paid on debt exceeding this set ratio is not tax-deductible. Earnings stripping rules limit the tax-deductible share of debt interest to pretax earnings.

Interest deduction rules, particularly thin capitalization rules, have been shown to reduce the value of firms and distort firm decisions about how to invest in capital. While interest deduction limitations can be seen as a way to address the debt bias inherent to most corporate tax systems, limiting the tax deductibility of interest expenses creates new distortions if interest income continues to be fully taxed.

Countries that limit interest deductions with only transfer pricing regulations receive the best score. Countries with debt-to-equity ratios receive an average score, and countries with interest-to-pretax-earning limits receive the worst score.

Global Minimum Tax

There has been a strong movement towards taxing large multinational enterprises based on their global accounting profits. The proposal for a global minimum tax will dramatically change the landscape for cross-border tax rules. Many OECD countries are proceeding to implement the global minimum tax rules. These contain three main components: 1) a QDMTT, 2) an IIR, and 3) a UTPR. The minimum tax rules are risky because they define the corporate tax base in a way that is less than ideal, favoring non-refundable tax credits and incentivizing subsidy races detrimental to global trade, while not properly accounting for features of a tax base, such as full expensing.

Countries adopting global minimum tax rules are rated worse.

General Anti-Tax Avoidance Rules

Many countries apply general anti-tax avoidance rules to tax multinational companies with business structures designed specifically for tax advantages rather than economic reasons. These rules often follow the substance over form principle in determining how profits should be taxed.

These complex tax regimes result in high compliance costs for multinational companies as well as double taxation of some corporate profits.

Anti-abuse provisions of this nature are not currently accounted for in the Index.