The transfer pricing regime in Mexico is not new; it is about to reach its 25th anniversary. Since its establishment in 1997, taxpayers have been required to obtain supporting documentation demonstrating that “prices and compensation amounts are agreed upon as independent third parties would in comparable transactions.” In other words, it must adhere to the arm’s length principle established in Article 9 of the OECD Model Tax Convention.
To prove that intercompany transactions indeed comply with the arm’s length principle, a specific documentation “protocol” must be followed. This protocol requires that, for each transaction carried out, the following information is reported: (i) transaction characteristics, (ii) functions, assets, and risks, (iii) contractual terms, (iv) economic circumstances, and (v) business strategies. These elements help “portray” the attributes of the analyzed transaction (e.g., purchases, services, royalties) to build a reference parameter that substantiates that the negotiation dynamics reflect those that independent third parties would consider in comparable transactions.
For documentation purposes, merely complying with the regulatory framework established in Mexican tax provisions is not enough. The last paragraph of Article 179 of the Mexican Income Tax Law (LISR) states that, for the interpretation of the regime, and unless otherwise specified, it is necessary to refer to the 1997 OECD Transfer Pricing Guidelines or their subsequent versions. Currently, the applicable guidelines are from 2017, incorporating recommendations from the OECD’s action plan to combat tax avoidance and profit shifting (the BEPS plan, short for Base Erosion and Profit Shifting). The BEPS plan, in Actions 8-10 (alignment of transfer pricing with value creation), provides specific clarifications on critical issues for the proper functioning of the regime, such as the recharacterization and disregard of transactions, risk allocation and the economic capacity of parties to absorb them, intangibles, services, and financial operations. Furthermore, Action 13 of the BEPS plan (country-by-country reporting and transfer pricing documentation) restructures documentation practices, shifting from a “standalone” local report (commonly known as the transfer pricing study) to a three-tiered documentation system. This system requires reporting the distribution of revenues, profits, and taxes paid by the multinational group (the country-by-country report), the group’s transfer pricing policies and organization (the master file), and an analysis of the arm’s length condition of each intercompany transaction reported by the taxpayer for the fiscal year (the local file). Action 13 of the BEPS plan is incorporated into the LISR under Article 76-A.
Despite these regulations, interpretations of the arm’s length standard in Mexico vary widely, and in many cases, supporting documentation lacks the necessary elements, either in substance or form. In response, tax authorities have issued clarifications through regulatory criteria, non-binding criteria, miscellaneous resolutions, and even FAQ responses on the SAT (Mexican Tax Administration Service) website. This has led to additional regulations regarding the identification of unique and valuable contributions in the form of intangibles to a multinational group’s business, adjustments to values within the interquartile range, corrections to taxable income or deductible expenses, and clarifications on formulas related to comparability adjustments.
Against this backdrop, the 2022 tax reform proposal tightens the screws on taxpayers by suggesting changes to the documentation practices of intercompany transactions. The first change pertains to how a transaction is “portrayed,” requiring that the functional, asset, and risk analysis consider the contributions of all parties involved, not just the entity under analysis. This aims to discourage the improper use of the transactional net margin method and emphasize profit split methods. Another relevant change relates to the period under analysis. In Mexico, it is common practice to use averages (whether simple or weighted, usually over a three-year period) to compare the taxpayer’s gross or operating profit margin with that of comparable entities. The reform proposal limits this practice to cases where the taxpayer’s results are affected by business cycles in their industries, making it impossible to capture the transaction’s profitability in a single fiscal year.
Regarding the use of profitability-based methods (resale price method, cost-plus method, and transactional net margin method), the reform proposal requires taxpayers to disclose the adjustment formulas used to eliminate differences between the analyzed entity and the proposed comparables. The taxpayer’s results must be shown within an interquartile range as the predominant measure for analyzing the arm’s length condition of a transaction (which, for example, would eliminate the use of minimum and maximum values for constructing intervals).
Finally, it is essential to consider the deadlines for documentation preparation: May 15 for the local file (an early date, given that by then, not all information on public companies used as references is available) and December 31 for submitting the master file and country-by-country report.
Given these changes, taxpayers must review their documentation practices, prioritizing the confirmation of the economic substance of transactions and alignment with the standard required by the LISR under the tax reform proposal. A “mechanical” approach to transactions without proper analysis should raise red flags, as it may create a false impression of compliance while leaving loose ends that could later result in costly penalties. These penalties could include the disallowance of intercompany expense deductions, leading to a recalculation of the taxable base—with serious financial consequences.
