By Mauricio Monroy, Deloitte
On January 1, 2008, a business flat tax (flat tax), also known as IETU, its Spanish acronym, became in force in Mexico. The tax was enacted through a decree published on October 1, 2007 in the Mexican official gazette.
The flat tax is a minimum tax that will coexist with the income tax. Its taxable income is computed by deducting from gross cash revenues a number of limited deductions, also on a cash basis. The taxpayer is liable to pay the higher of the income tax or the flat tax. Regulations and other interpretation guidelines from the tax authorities are generally published in connection with a tax law. Such is the case of a presidential decree published on November 5, 2007, which granted a number of flat tax incentives, some expressly addressed to the real estate industry.
The flat tax rate is 17.5% (16.5% in 2008 and 17% in 2009). The level of rates will be subject to evaluation by the tax authorities after 2008.
The flat tax law calls for the tax authorities to evaluate by 2011 the repeal of the corporate income tax law for corporate entities and individuals that carry out business activities. This means that the flat tax could thereafter replace the traditional corporate income tax.
As stated above, since the intention is to have the flat tax operating as a minimum tax, the asset tax law that used to levy a minimum tax of 1.25 percent of business assets was repealed as of January 1, 2008. This is good news to U.S. investors because the asset tax was not creditable as a foreign tax credit in the U.S., and the IRS has accepted the credit of the flat tax for U.S. tax purposes, at least until 2011.
The flat tax considers three categories of taxpayers: 1) corporate entities resident in Mexico, 2) individuals engaged in business activities, and 3) nonresidents with a permanent establishment in Mexico on the income attributable to such PE. Accordingly, nonresidents without a PE in Mexico are not taxpayers of the provisions may affect them, as discussed below. For real estate and surrounding activities, income received by a nonresident without a PE that will not be subject to the flat tax, would include Mexican source income of construction services (lasting six months or less), professional services, or commissions. However these types of income will stay taxed at the regular income tax withholding rates established in the income tax law, or if applicable, the rates included in the treaties to prevent double taxation.
As stated above, the taxable income for flat tax purposes, is the excess of gross taxable cash receipts over limited cash deductions. Gross revenues are limited to those arising from the following:
- Alienation of goods;
- Provision of independent services; and
- Granting the temporary use and enjoyment of goods.
The deductible payments include the ones related to such three concepts, as well as those incurred for the management, production, trading, and distribution thereof.
When one reads the law, the formula is not as simple because exceptions and rules for recognition of income apply. For example, if payments are totally or partially made in kind, the fair market value of consideration or an appraisal should be considered to determine the amount of the taxable revenue.
The big items missing in the allowable deductions are payroll, employee welfare, and interest. The first two items are not deductible for the flat tax; however, a tax credit is granted equivalent to the taxable portion of the payroll (some payments to employees are nontaxable) and the social security contributions. This credit is equivalent to 17.5 % of the taxable payroll and social security contributions (16.5 % in 2008 and 17 % in 2009).
An item of special concern to real estate developments is interest. As stated above, payments of interest are non deductible for flat tax purposes, regardless that they can be made to a Mexican or a non resident or to a related party or to an independent financing entity. Furthermore, no credit is granted on the payment of interest. As to interest collected from customers, such cash receipts are non taxable, unless they are included in the selling price.
Against the annual tax, taxpayers may also claim (besides the payroll and social security contributions discussed above) a credit for income tax actually paid, as well as other credits for property not fully depreciated for income tax purposes as of December 31, 2007. Since monthly flat tax deposits are required, they will be deducted from the annual flat tax liability.
Real Estate Projects
Real estate projects comprise a number of special tax situations that have been adequately addressed in provisions of the income tax, value-added tax (VAT), and real estate transfer tax laws. Those rules contemplate provisions that take into account how a real estate project works and, generally, try to levy taxes in line with how the cash flows behave. On the other hand, in the past few years, Mexico has granted tax incentives to real estate developers to promote their business.
However, the flat tax law does not contemplate specific provisions for real estate operations. This leads to some adverse situations, as discussed below, but also secures some benefits. To evaluate the overall impact in a project, a case-by-case analysis is required. Under current legislation, the flat tax consequences for a project in progress with inventories or construction in progress as of December 31, 2007, are radically different from the flat tax consequences for projects that began operations in 2008. The next section discusses some of the special challenges, including a summary of the incentives established in the November 5 decree.
Sales or Time Shares
In a typical tourism real estate development, there may be three principal categories of assets that can generate income: units and lots for sale, units dedicated to time share contracts or “fractionals” and facilities for rent.
In order to define the scope of the three main taxable activities of the law referred to above, the flat tax law states that reference should be made to the VAT Law. Based on such law, the gross income from the sales of units or lots and rent of facilities would be subject to the flat tax.
This is because income from the sale of units and the rent of facilities are directly covered by the scope of the VAT law under alienation of goods and granting temporary use or enjoyment of goods.
However, time shares and “fractionals”deserve further analysis.
The VAT law considers time share contracts to be contracts for granting the temporary use and enjoyment of property. Based on such text, income from time share contracts earned by Mexican residents should be considered taxable for flat tax purposes. Nevertheless, since time share contracts have diverse forms that may go beyond the VAT law’s definition of time shares, as stated above, and time share contracts may even be entered into by a nonresident without a PE in Mexico, a case-by-case analysis is deserved.
For example, the case of time shares based on points that allow the customer to redeem the points to enjoy facilities located in any of different countries.
“Fractionals” is a U.S. concept that has been adapted into Mexican law under different approaches. Documentation of “fractionals” in Mexico, include the straight alienation of property under a common property regime that would be taxable under alienation of goods. But “fractionals” are sometimes documented under legal documents that, from a tax standpoint, rather mimic a time share and could fall under the scope of granting temporary use or enjoyment of goods. Finally, there are structures when the transaction is carried out by a nonresident without a PE in Mexico, which creates an uncertain tax situation.
As stated above, revenues are taxable on a cash basis; accordingly, the moneys received in presale campaigns may trigger undesirable situations, since advances and deposits are considered taxable.
The income tax law and its rulings contemplate mechanisms under which there may be a partial taxation of advances received or a current deduction of future disbursements that may be claimed against income from advances or deposits. This has helped developers to have a fair taxation of their presale revenues. Under the provisions of the flat tax law, no such mechanisms are currently contemplated. Unless the regulations or future rulings establish rules similar to the ones contemplated for income tax purposes, income from presales in the form of advances or deposits will represent a challenge to developers.
Deductions to taxpayers are limited. The relevant situations under the flat tax law that apply to developers are summarized below.
Taxpayers are allowed to claim deductions for the payments for the three taxable activities of the law: acquisition of goods, independent services received, and temporary use and enjoyment of goods, provided that such payments are required to conduct the taxable activities, or for the management, production, trading, and distribution thereof.
In particular, developers will be able to claim a deduction of land acquired. This seems to be an advantageous situation compared with the incentive granted to developers under provision of the 2007 income tax law. In order to enjoy the 2007 incentive, the taxpayer has to report phantom income of 3 percent of the basis of unsold land at the end of each year and to lock the election for all land acquired for five years. Bear in mind that this incentive for income tax purposes, coexists with the flat tax provision that allows an immediate deduction of land purchases, provided that they are paid in cash in the fiscal year as established in the law.
Once the project gets started, based on the general rules, the payments for the acquisition of materials, independent services received, and rent of construction equipment among others, are allowable deductions. For example, allowable deductions also include the payments for infrastructure, buildings, and common areas.
As opposed to the income tax law, under whose provisions the construction in progress of, say, residential units, is deductible until the units are sold, under flat tax provisions the payments for acquisition of materials, independent services, and rent of equipment for the construction of residential units will be deductible on a cash basis.
Therefore, depending on how the project develops, tax consequences will vary. For example, if in 2008 land is acquired and paid, construction of infrastructure and buildings gets started and paid, and limited presales occur, there may be a tax loss carry forward for flat tax purposes that may be carried forward for 10 years. However, a project that acquired land in 2007 and that developed and paid most of its infrastructure and buildings in 2007 will have a challenge when starting its presales and full-blown sales campaign in 2008 or thereafter, because it will have gross taxable revenues and limited deductions for flat tax purposes. The law grants credits on new investments made from September 1, 2007, to December 31, 2007; however, the real impact is not significant because the credit is limited to fixed assets, not inventories, and only one-third of the credit may be applied each year beginning with 2008.
Since the flat tax and the traditional income tax coexist, the scenarios under either law may be different but, at the end, the greater of the taxes is the one to be paid.
Two items deserve further comment: VAT and payments to nonresidents.
Under Section II of article 5 of the flat tax law, the VAT that cannot be creditable to a taxpayer may be deducible for flat tax purposes. This mimics the treatment of VAT for income tax purposes for developers of residential units. Under the VAT law, the revenues from the sale of residential units are nontaxable for VAT purposes; accordingly, the VAT paid to vendors is not creditable and becomes part of the cost of goods sold.
Payments abroad or payments to nonresidents without a PE in Mexico, will be deductible if, had they been incurred in Mexico, they would have been deductible for flat tax purposes. This is ambiguous language; the deductibility requirement is a discussion beyond the scope of this article and includes a number of conditions, one of which is that the recipient of the payment be subject to the flat tax. A nonresident without a PE in Mexico is excluded in “ contrario sensu” as a flat taxpayer. Accordingly, it is advisable to ascertain that payments to nonresidents meet the conditions to be deductible for flat tax purposes.
Based on the general condition for deductions, the payments to nonresidents without a PE in Mexico for, say, architectural services, commissions, and other support services, are deductible for flat tax purposes.
A special case would be the payment for construction-type services to nonresidents. In order to define whether or not a nonresident has a permanent establishment in Mexico, provisions of the income tax law should be taken into account. This is important in the case of construction-type services that last less than six months , as it seems that, since they are not subject to IETU because the recipient is not deemed to have a permanent establishment in Mexico, the payments would appear not to be deductible to the Mexican developer.
The general rule is that the payments to related parties for royalties, stemming from the use or enjoyment of goods, are not considered to be under the scope of the law. Accordingly, such royalties are not taxable for flat tax purposes. On the other hand, the same treatment negates the deduction of those payments to the Mexican taxpayer. Therefore, royalties paid to nonresident related parties are nondeductible for flat tax purposes.
The payments connected with the temporary use or enjoyment of industrial, commercial, or scientific equipment are deemed taxable income for flat tax purposes, which causes the payments to become deductible. The tax liability for a recipient who is a nonresident is not addressed in the law; however, based on the general rule that governs the definition of taxpayers, the income from rent of this type of equipment is not taxable for flat tax purposes to nonresidents without a PE in Mexico.
November 5 Presidential Decree
The November 5th decree includes some provisions addressing real estate operations, as well as provisions that are addressed to other operations but that could also apply in some cases to real estate operations, such as a special treatment to installment sales.
The decree grants an incentive equivalent to a tax credit of 17.5 % (16.5% in 2008 and 17% in 2009 of inventories on hand as of December 31, 2007. The decree states that inventories include land and constructions if:
- land and constructions are dedicated to be sold in the normal course of operations of the taxpayer; and
- the land was not subject to the tax incentive of the income tax law granted to developers, which allows an immediate deduction of land acquired.
The tax credit, as computed above, could be reduced from the flat tax in the following 10 years, beginning with 2008, at the rate of 6 percent of the incentive per year. This means that the taxpayers will eventually be able to use 60 percent of the tax credit, although this may be adjusted for inflation annually. Assuming inflation of around 3 % per year, the inflation adjusted credit would approximate 100 % of the 17.5 % of the inventories on hand as of December 31, 2007. The tax credit may also be used to offset monthly flat tax estimated tax payments.
The flat tax is an entirely new tax that, based on its presentation to the Mexican Congress and the content of its legal provisions, is planned to eventually become a substitute of the current income tax system. There is no doubt that regardless of the November 5th decree, a number of questions remain and that abundant clarifications are expected through regulations and rulings. Nevertheless, because of its complexity (paradoxically against the spirit of a simple flat tax and in view of the potentially adverse consequences to the real estate industry, it is advisable to promptly evaluate its impact, to get prepared, to have proper compliance, and to maximize the available credits and incentives as established the law and the November 5 decree. Finally, taxpayers should discuss with their lawyers whether an “amparo” (injunction) to suspend the enforcement of the flat tax would be advisable in their circumstances.
Mauricio Monroy is a Tax Partner and the Managing Partner of the Deloitte office in Tijuana, Mexico. He can be reached at firstname.lastname@example.org