Overview of Mexican Tax System for Cross-Border Commercial Activities (State Taxation) February 15, 2007 Course 5B MODER

1. Overview of Mexican Tax System for Cross-Border Commercial Activities (State Taxation)February 15, 2007 Course 5B MODERATORLiliana Sandoval, Esq. SPEAKERS Lic. Luis Santos TheriotC.P.C. Daniel Cano Falomir

2. “Overview of Mexico’s tax system regarding U.S. - Canadian Business and Commercial activities in Mexico”Luis Santos-Theriot Daniel Cano-Falomir

3. AGENDA • Doing business or commercial activities in Mexico • Direct transactions by US and Canadian residents. • Permanent Establishment (Branch). • Mexican Subsidiary. • Tax Losses. • Mandatory Employee Profit Sharing. • Sale of Shares • Profit distribution (Dividends) tax structure. • Thin Capitalization rules. • Asset Tax. • Value Added Tax.

4. DISTRIBUTION OF GOVERNMENT TAX POWERS MAIN TYPES OF TAXES GOVERNMENT LEVEL • INCOME TAX • VALUE ADDED TAX • ASSETS TAX • EXCISE TAXES FEDERAL STATE MUNICIPAL • PAYROL TAXES • PROPERTY TAXES • REAL ESTATE ACQUISITION • TAX

5. ALTERNATIVES FOR DOING BUSINESS IN MEXICO Foreign Co. C USA -CAN B A MEX Branch USCO Inc. MexCo, SA, SRL or SAPI Foreign Resident for tax purposes

6. STRUCTURE OF OPERATIONS FOR INCOME TAX IN MEXICO • All individuals and corporations are subject to pay income tax in Mexico, under the following circumstances: • If they are residents in Mexico, obligation to pay income tax includes all revenue, even if sourced out of Mexico.

7. STRUCTURE OF OPERATIONS FOR INCOME TAX IN MEXICO • Foreign residents with Permanent Establishments (PE) in Mexico, are subject to pay for the income that is attributable to that PE. • Foreign residents whose revenue is sourced in Mexico, only if: • Do not have a PE in Mexico, or they have a PE but that revenue is not attributable to such PE.

8. “ALTERNATIVE A”Foreign Resident for Mexican tax purposes • Foreign residents that have no PE in Mexico will be subject to pay in Mexico for all revenue received in cash, goods or services, as long as those revenues are sourced within Mexico. • Payment method and due date. • Payment of the Income Tax is ussually aplicable thru a withholding method, and the tax has to be paid either on payment date or on the due date of payment, whichever is first.

9. “ALTERNATIVE A”Foreign Resident for Mexican tax purposes • Withholding payment • It’s usually done by the Mexican resident who performs the payment, or by the foreign resident if payment is done thru a PE in Mexico. • On some cases, payment might be due directly from the foreign resident. • Option to be taxed on Net Basis on certain types of income: Need to appoint a Legal Representative in resident in Mexico

10. “ALTERNATIVE A”Foreign Resident for Mexican tax purposes • Type of income for Foreign residents • Salaries and professional fees. • Lease of goods. • Sale of real estate. • Sale of shares. • Dividends. • Interest. • Financial Lease. • Royalties and Technical Assistance. • Construction. • Artists and athletes.

11. SUBSIDIARY VS. PE • Mexican Subsidiary • Worldwide income is taxable • Transfer pricing rules • Reduced liability exposure (SA, SRL, SAPI) • Permanent establishment (Branch) • Only taxable on attributable income • Payments to parent company non-deductible • “Corporate veil” easily broken, liability for USCO. • Not for “Maquila” purposes.

12. “ALTERNATIVE B”Permanent Establishment • Any fixed place of business, where full or partial business activities are performed. • Among others, the following are usually considered PE’s: • Branch, agency, office, factories, workshops,any place for extraction or exploration of metals. • Foreign Residents that operate thru a person different that an independent agent. • Are considered a PE, especially if this person has power of attorney to act in behalf of the US – CAN resident.

13. “ALTERNATIVE B”Permanent Establishment • When the Non Residentoperates thru an independent agent, it will be considered a PE if the agent meets the following criteria: • The agent does not operate under its ordinary scope of activities. • The agent has in existence good and merchandise which he delivers on behalf of the foreign resident. • Assumes risk that belong to the foreign resident. • It is subject to detailed instructions and control from the Foreign resident. • Receives pay, without taking into consideration the end result of the activities

14. “ALTERNATIVE B”Permanent Establishment • Construction services • Applies to building, demolition, instalation, instalation, projection and supervision activities. • PE is considered when the Foreign resident operates in Mexico more than 183 days (consecutive or no) in a 12 month period.

15. “ALTERNATIVE B”Permanent Establishment • The ITL does not consider a PE under the following circumstances: • The use of facilities with the objective of exhibiting or storing goods or merchandise. • The purchasing of goods or merchandise to send to foreign land. • Preparatory or auxiliary activities • The use of bonded warehouses.

16. “ALTERNATIVE C”Mexican Subsidiary Before starting any venture in Mexico, any Investor needs to define several KEY ISSUES such as: • Financing-Debt Vs Equity. • Foreign tax credit utilization. • Global Effective tax rate minimization. • Exit strategy. • US investor composition (individuals, corporations, pension funds, etc.) Non-US investors. • US management oversight, commissions, or any other services.

17. “ALTERNATIVE C”Mexican Subsidiary • Type of corporate structure. - Tax treatment is the same for Mexican purposes.

18. Entity Classification • Under the US “check the box” rules, US investors have the ability to elect the entity classification and US tax treatment of an eligible Mexican corporation. • A Mexican Sociedad de Responsabilidad Limitada de C.V. (“SRL”) is an eligible entity that can be treated as a foreign corporation or disregarded entity/partnership (“flow through”).

19. Entity Classification • US check the box election does not impact Mexican taxation. • Treatment of the SRL as a partnership for U.S. tax purposes may allow the US individual to pay lower total worldwide taxes attributable to the benefit of using US foreign tax credits from the direct corporate foreign taxes paid in Mexico and avoiding double taxation.

20. GENERAL MEXICO INCOME TAX ISSUES • Corporations and Permanent Establishments are taxed by the determination of the net taxable income, which is determined by the income less the deductible expenses for the year. • One Federal Corporate Income Tax rate • 2007 – 28% • No state income tax • Previous year losses may be reduced.

21. TAX LOSSES • Possibility to carry forward for 10 years - No carry back. • Possibility of adjusting with inflation. • First year with Index rate from July to December • Following years from December to June of the year of amortization.

22. TAX LOSS INFLATION ADJUSTMENT TAX LOSS 2005 $256,829.00 1st. Adjustment December 2005 July 2005 ADJUSTED TAX LOSS 263,372.00 2nd. Adjustment June 2006 December 2005 ADJUSTED TAX LOSS $267,618.00

23. MANDATORY PROFIT SHARING • Mandatory 10% employee profit sharing. • 1 year holiday. • No inflation accounting. • Dividends received counts as income (not for IT). • Tax losses may not be carried forward. • Not a tax, which means no FTC in most countries.

24. MANDATORY PROFIT SHARING (2006) Total revenue. ( - ) Allowed Deductions. -------------------------------------- Taxable Profit ( - ) Paid Profit Sharing (*) ( - ) Previous Years Tax Losses -------------------------------------- (= ) Net taxable income (*) Starting in 2006

25. SALE OF SHARES US - CAN Co 100% US - CAN Co Sale of Shares Shares Mex Co

26. SALE OF SHARES • Withholding of 25% over gross sale price or 28% over profit if foreign resident appoints a legal representative In Mexico, and the transaction is audited by an independent CPA. • Cost basis is determined by • Original cost • (+) Inflation adjustment • (-) Tax losses incurred • (+/-) Difference in balance of the NATPA account

27. PROFIT DISTRIBUTION • Under Mexican income tax law, profit distributions are only taxed once at the corporate level. • Profits distributions include not only dividend payments but also reimbursement of shares due to corporate capital reductions or a company’s liquidation.

28. NET AFTER TAXPROFITACCOUNT (“NATPA”) Net taxable Income (-) Income tax paid (-) Non deductible expenses (-) Non deductible profit sharing (=) Net After Tax Profit Account

29. ACCUMULATIVE NET AFTER TAXPROFITACCOUNT (“NATPA”) Net After Tax Profit Account (+) Received Dividends (-) Distributed Dividends fron NATPA account (=) Accumulative Net After Tax Profit Account

30. PROFIT DISTRIBUTION • If Dividend comes from NATPA no Income Tax is paid. • If payment exceeds NATPA or there is no balance in this account, corporation pays the Income tax for such distribution in accordance with these factors: Year Factor Rate 2006 1.4085 29% 2007 1.3889 28%

31. PROFIT DISTRIBUTION • If Income Tax is paid for profit distribution, the amount paid is fully creditable versus the corporate Income Tax of the corporation. • This credit is allowed in the year of the profit distribution or the following two years. • No inflation adjustment is allowed.

32. PROFIT DISTRIBUTION-EXAMPLE Example: Company Corona-Tequila,S.A. de C.V. distributed dividends on january 30th 2007, for the amount of $ 650,000.00, at that date NATPA account had an adjusted balance of $ 500,000. Total dividend distribution on January 2007: $ 650,000.00 Adjusted balance of the NATPA account at the Date of distribution: $ 500,000.00 Distributed Dividends that exceed the NATPA account: $ 150,000.00 NATPA balance after distribution: $ 0.00

33. Profit Distribution-Example Determination of Income Tax due for the distributed dividends that exceed the NATPA balance: Dividendss that exceed the balance of NATPA: $ 150,000.00 (X) Gross up factor: 1.3889= Result: $ 208,335.00 (X) Income Tax corporate rate: _ 28% =Income tax payable for profit distribution(*): $ 58,333.80 (*) This tax is fully creditable for the Income Tax of the corporation for 2007, 2008 or 2009 (Art. 11 LISR)

34. THIN CAPITALIZATION RULES US-CAN Co Capital? Debt? Mex Sub

35. DEBT VS. EQUITY • Since 2005, “Thin capitalization” rules, limit of 3 to 1 ratio for Debt versus equity. • Debt • Interest deduction in Mexico. • Inflationary “gain” reduces interest deduction. • Loans denominatedin US Dlls and record exchange losses to hopefully offset impact of inflationary gain. • 4.9 W/H tax on interest paid to US banking institutions. • 15% W/H tax on interest paid to US residents other than banking institutions.

36. DEBT VS. EQUITY

37. DEBT VS. EQUITY • Equity • Inflation adjustment on equity added (capital increase) to stock basis. • No W/H tax on dividends to the extent of NATPA (Fiscal Net Income Account). • Investment can be repatriated as a reimbursement of investment without any tax implication. • Only if original contribution is higher than equity at the time of reimbursement • If not deemed a profit distribution.

38. DEBT VS. EQUITY • Equity, treatment of sale. • Any change of ownership is subject to tax. • Election to net gain taxation upon prior consent from Tax Authorities. • Stock basis step-up for undistributed earnings and step-down for losses.

39. THIN CAPITAL RULES • Interest paid will not be deductible if company falls under thin capitalization criteria. • A company is considered thinly capitalized when the liabilities exceed 3 times the amount of equity. • If any of the liabilities come from a related entity.

40. THIN CAPITAL RULES Determination of Excess of Liabilities over equity ( ) - Average of Interest Bearing Debt Average Equity (Beg. Balance + Ending Balance) x 3 2 S Final Monthly balance # of months of the year

41. THIN CAPITAL RULES Interest Bearing debt from related parties All interest of related parties are non deductible Excess of debt over equity > =

42. THIN CAPITAL RULES Interest of related parties are proportionally non deductible. Interest Bearing debt from related parties Excess of debt over equity <

43. THIN CAPITAL RULES Procedure to be followed if interest bearing debt from related parties is higher than the excess of debt over equity. Excess of debts Annual debts average x = Non deductible interest Accrued annual interest

44. THIN CAPITAL RULES

45. THIN CAPITAL RULES

46. TAX ON ASSETS • An alternative minimum tax. • 3 year carry back, 10 year carry forward. • 1.25% on the average value of assets. • 4 year holiday. • Except for leasing. • Interrupted upon mergers, spin offs and transformation. • No FTC source credit for US resident.

47. MAJOR INCENTIVES • Deduction of Land Purchases in the year when acquired. • Taxpayers devoted to construction and sale of RE developments • Conditions: • RE developments for sale • At least 85% revenues from RE developments • 5 year election for all land purchases • 3% additional taxable income

48. MAJOR INCENTIVES • Accelerated depreciation for Fixed Assets. • Construction depreciated at 74% • Computer Equipment 94% • Most industrial equipment 87% • One time. • On new or newly imported assets only. • Can be applied on: • Year of investment, • first year of usage, or • Following year. • Balance written off at time of sale or disposal.

49. MAJOR INCENTIVES • Tax Consolidation up to 100%. • Mexican consolidation of taxable income if investment consists of multiple companies. • Direct consolidation of Tax Losses of any company to offset the Tax profits from another entity.

50. TAX ON ASSETS I. Monthly average of financial assets (+) II. Average Value of Fixed Assets (+) III. Average value of Land (+) IV.Average Value of Inventory TOTAL BASIS X 1.25% RATE (=) TAX ON ASSETS Starting 2007 liabilities are no longer reduced from the Asset basis