On December 31st, 2000, the Official Gazette of the Federation (the Mexican government’s bulletin where new laws and amendments are published) included amendments to article 58, section 14 of the Mexican Income Tax Law (MITL); a section that deals with transfer pricing regulations. These modifications have the potential to drastically change transfer pricing studies in Mexico and, more importantly, may uncover previous transfer pricing irregularities.
Although Mexico, as an OECD member, has adopted most of the OECD’s transfer pricing guidelines, there is an important omission in regards to the reasonable method criteria (which includes the preference of transaction based methods over profit based methods).1 Although the Mexican transfer pricing legislation lists and describes the approved methods, it stops short of establishing a priority of methods. This latitude, coupled with the fact that since very few tax audits have been performed there have been even fewer challenges to the methods used, has translated to an overabundance of reports relying on a single, all-encompassing analysis using the Transactional Net Margin Method (TNMM).2
The reasoning behind the popularity of these single TNMM analysis reports is easily identifiable in terms of the following criteria: simplicity, efficiency, and cost. The TNMM requires much less information (especially the specific transaction information which is oftentimes difficult to get) and is more tolerant to transactional and functional differences than any of the more direct transactional methods. Furthermore, since the TNMM uses the net margin as its profit level indicator, a positive result means that all the transactions undertaken by the tested party (both related and unrelated) produce an aggregate result which is in accordance with the arm’s length principle. Although this does not mean that each and every transaction is set at market values, it does suggest that their netted effect is acceptable. Therefore, most of Mexico’s accounting firms have interpreted the TNMM as the method that, in one analysis, tests all related party transactions. Consequently, in practice the TNMM has become the default transfer pricing method because it requires less detailed information, does the work of what would otherwise take several analyses and, therefore, produces a finished transfer pricing report in a fraction of the time it would take to analyze each related party transaction independently.
This process will significantly change beginning with transfer pricing reports documenting fiscal year 2001. The modification to the Mexican transfer pricing laws published on December 31st, 2000 set forth new requirements which require transfer pricing studies to evaluate each related party transaction independently. Most likely this reform will cause those companies that provide transfer pricing report services to begin using transactional methods. This means that the individual related party transactions will be more closely scrutinized and, in contrast to the TNMM, will eliminate the possibility that non-arm’s length transactions may remain undiscovered when viewed in conjunction with the total of all transactions.
As a result, it is very likely that some transfer pricing analyses which previously documented intercompany transactions as being at arm’s length will now produce results that would suggest transfer pricing contingencies. If these companies do not have any significant differences between their current operations and those prior to 2001, the obvious conclusion would be that the transfer pricing contingencies are not new. This opens the door to transfer pricing adjustments for several years that may have serious tax implications.
Although the aforementioned tendency is a distinct possibility, this reform still does not address the best method rule, thus leaving the possibility for a legal loophole. In this respect, it is important to point-out a few facts. Even though the reform requires related party transactions to be analyzed individually, it does not require the use of transactional methods. Moreover, although the MITL lists and explains the approved transfer pricing methods, it does not make a distinction between transactional and profit based methods. Furthermore, the transfer pricing reform’s only technical requirement is that the functions, assets and risks considered are related to the operation analyzed. 3 In light of these circumstances, it is possible to use the familiar TNMM and still comply with the letter of the law. Adjustments to financial information that would more narrowly address a particular transaction (i.e. financial statements segmented by business unit) would allow for a "transactional" TNMM analysis that is arguably in compliance with the reform.
The purpose of the preceding paragraph is not to suggest a course of action (one which most likely circumvents the intent of the reform) but rather to highlight two important points. First, although the continued use of the TNMM would be controversial to say the least, the huge tax implications might pressure some of Mexico’s accounting firms to find any legal means necessary to continue giving their transfer pricing clients a clean bill of health; especially since their previous studies reassured them that they had no transfer pricing irregularities. Secondly, the existence of this loophole exemplifies the ambiguity that has plagued the Mexican transfer pricing legislation. This ambiguity is one of the main obstacles that has thus far hindered the development of the transfer pricing practice in Mexico.
Although the transfer pricing reforms implemented on December 31st, 2000 represent a clear threat to the way transfer pricing consultants have been operating, this legislation is faulted in the same way that the original law was: its ambiguity. Even though this latest reform does little to clarify the Mexican transfer pricing legislation, it has the potential to uncover transfer pricing irregularities which would translate to significant additional tax impositions. When viewed in context with the Mexican Tax Authority’s desire to increase tax revenues, this reform should be cause for alarm for all companies operating in Mexico who carry out operations with related parties resident abroad.
1OECD Guidelines; paragraph 1.70
2Actually, in Mexico the TNMM is known as the Transactional Operating Profit Margin Method (TOPMM). However, in all practicality, the TOPMM is virtually indistinguishable from the TNMM which, in turn, is practically identical to the Comparable Profit Margin Method (CPM) used in the United States.
3Mexican Income Tax Law Article 58; section XIV; paragraph b.
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