Mexican Supreme Court rules flat tax is constitutional

The Mexican Supreme Court has ruled that the Business Flat Tax (or IETU) is fully compatible with the Mexican Constitution. The IETU, introduced in 2008 to replace the asset tax, is designed to operate as an alternative minimum tax, with a view to reducing tax avoidance / Tax evasion and to ensure that taxpayers either pay income tax or the IETU. Under the IETU, corporations (including permanent establishments of foreign entities) and individuals must pay the sum of the income tax computed under the Income Tax Law and the excess of the IETU. Tax liability is calculated on a cash-flow rather than an accrued basis. The IETU mainly targets income derived from the sale of goods, the provision of independent services and the granting of the right to use certain assets. The tax base for purposes of calculating IETU liability is determined by reducing taxable revenue with limited, authorized deductions (for example, no deduction is allowed for interest and royalties and, with respect to salaries, wages and fringe benefits, no deduction is allowed except for the portion that is subject to income tax). The flat tax liability is computed by applying the flat tax rate (currently 17.5%) to this enlarged tax
base.

Many taxpayers considered the flat tax to violate the equal treatment and proportionality principles in the Mexican Constitution because of the limited deductions and the different treatment of such expenses, and a record number of lawsuits (amparos) were filed before the district judges in February 2008. After a sui generis process, by which two district judges were asked by the Supreme Court to review all of the amparos and issue a first-level decision, the Supreme Court decided to analyze taxpayers' arguments to determine the criteria to be followed by the appellate courts in all proceedings. In an unprecedented procedure – at least regarding fiscal issues – the Supreme Court held a public hearing on the amparo lawsuits and invited government representatives and taxpayers to present their arguments in 10-15 minute oral presentations. Representatives from the Ministry of Finance, the General Fiscal Attorney´s Office, the Senate and the House of Representatives were invited on behalf of the government, and representatives from the Mexican Bar Association, the Illustrious Lawyers´ Collegiate Body, the National Association of Business Lawyers and the Coordinating Enterprises´ Council were summoned to appear on behalf of the taxpayers. The fact that the Court initiated this procedure created optimism for a taxpayer-favorable decision, but in February the Court upheld the constitutionality of the IETU. The Court also took the opportunity to comment on various aspects of the challenges to the IETU.


Purpose and nature of IETU and principle of fiscal legality

The Supreme Court concluded that the IETU and the income tax are separate and distinct from each other: they are two separate taxes, taxing different sources of wealth. In this regard, the Justices noted that the Mexican legislators are empowered to freely configure taxes, thus allowing them to design different kinds of taxes, including the IETU.

The Court agreed that the IETU is a "control" tax and noted that it applies to gross income derived from the sale of goods, the provision of independent services and the leasing of goods, despite the fact that certain deductions are permitted in calculating IETU liability. The ability to take deductions on a gross income-based tax was considered controversial and was one of the constitutional challenges, with a key argument advanced by taxpayers that there seemed to be inconsistencies in only allowing some deductions in computing IETU liability. (It should be noted that the fact that the IETU is levied on gross income potentially could jeopardize its characterization as a creditable tax in jurisdictions that require a tax to be levied on a basis similar to that of an income tax to be creditable.)

Reiterating that the IETU is applicable to gross rather than net income, the Court said that the legislators were not obliged to allow any deductions; in other words, by recognizing that the IETU can tax gross income, the granting of deductions becomes a discretionary act by the legislators and, therefore, taxpayers do not have any right to demand that certain expenses be considered deductible for IETU purposes.

The Court ruled that the IETU does not violate the constitutional right to fiscal legality (i.e. that all relevant tax elements be included in a law) because the IETU law clearly establishes the tax base and how it is determined. Taxpayers had argued that it was not clear what specific economic effect was taxed by the IETU.


Deduction of wages and salaries

The Court ruled that the disallowance of a deduction for wages and salaries is not disproportionate because wages and salaries are not considered taxable income in the hands of the employee. The Court noted that legislators recognized the effect of such a disallowance for taxpayers, so they decided to grant a tax credit for these expenses which "has the same economic effect as a deduction." This conclusion is technically erroneous because, even though it might have some merit from a mathematical perspective, a tax credit can only be used in certain circumstances, while a deduction effectively lowers the tax basis in all instances.

The Court further concluded that the limited deductibility of wages and salaries under the IETU does not violate the equity principle in the Constitution, even though other company operating expenses are considered deductible. Taxpayers had argued that the equity principle was infringed because, by allowing the deduction of other expenses that also can be considered related to the process of production, the IETU treats taxpayers that are in the same legal position differently.


Deduction of interest

In the case of financing or loan transactions that give rise to the payment of interest that is not considered part of the price and that does not refer to taxable activities, the Supreme Court held that the inability to deduct interest accrued on financing or loan transactions is neither disproportionate nor inequitable since interest is not accruable for IETU purposes in the hands of the creditor. Taxpayers had argued that the disallowance of an interest deduction violates the equity principle because the IETU effectively makes an unfair distinction between interest on financing transactions and loans that are not considered part of the price of a financed asset (nondeductible) and interest that can be considered part of the purchase price of a financed asset (deductible).

The Court failed to grasp the fact that loans are an important – and integral – part of doing business in Mexico. The fact that some taxpayers may use lending as an artificial way to erode their taxable base should have been specifically addressed in the law, not simply by disallowing interest deductions across the board.


Deduction of royalties paid between related parties

The Court rejected the taxpayers' argument that the different treatment of royalties paid to unrelated parties (which are deductible) and royalties paid related parties (which are nondeductible) also violates the equity principle. According to the Court, the different treatment is fully justified as a measure to prevent taxpayers from eroding the tax base based on the flexibility of transactions carried out with related parties.

In yet another superficial argument, the Supreme Court validated the fact that the IETU Law prohibits a general right, based on individual circumstances. If a taxpayer does "arrange" its royalty payments with a related party, this practice should be addressed in the law (e.g. under the transfer pricing provisions in the Income Tax Law) and not by presuming that all taxpayers are likely to manipulate royalty payments.

It is also disappointing that, in recent years, the Supreme Court rarely has found a tax treatment to be inequitable, under the superficial assumption that there are always differences between taxpayers that make it constitutional to treat them differently, without analyzing whether these differences are relevant for tax purposes.


Investments

Taxpayers argued that the IETU violates the equity principle in limiting their ability to deduct new investments made outside a period provided in the law (i.e. investments made from 1 September – 31 December 2007, and the credit applicable to investments made from 1 January 1998 – 31 December 2007). The Supreme Court rejected this argument because affected taxpayers are not in the same legal situation and, therefore, should not be treated equally. The IETU is determined based on cash flows in such a way that income is accrued when effectively received and deductions are applicable when the relevant payments are effectively made. This explains why the regulation of the IETU allows the total deductibility of investments in the year expenses are incurred and why the mechanism and the nature of the IETU prevents the deduction of investments made before the IETU was introduced, since the expenses were not incurred in the fiscal year in question.

This rationale ignores the fact that a taxpayer's activities were not created with the IETU Law, but are ongoing. In this regard, investments made before the IETU was introduced fully affect the taxpayer´s bottom line once the IETU became effective and should be fully recognized by the new law.


Net operating losses

The Court held that it is not unconstitutional for the IETU Law to exclude net operating losses (NOLs) incurred before 2008 because taxpayers do not have any acquired right to always pay tax according to the same basis or rate. Taxpayers had argued that the nonrecognition of pre-2008 NOLs violates the proportionality principle because it creates an artificial tax base. Because the IETU is an alternative minimum tax, pre-2008 NOLs recognized after 2007 for income tax purposes but not for IETU purposes would result in a higher flat tax base and, therefore, increase the chance of the IETU liability being higher than the income tax liability.

The Court's conclusion fails to correctly take into account the relationship between the income tax and the IETU, the latter being an alternative minimum tax. The fact that the IETU does not allow for pre-2008 NOL recognition effectively disrupts the relationship between the IETU and income tax.


Provisional payments

The Supreme Court ruled that the IETU does not violate the guarantee of fiscal proportionality even though it does not contain a mechanism for adjusting the amount of the advance IETU payments to accurately reflect the purpose of the tax. Unlike the income tax, which uses a profit ratio to determine the advance payment, the IETU relies on an actual calculation of the income and deductions for the relevant month.


Asset tax recovery

The Supreme Court ruled that the transition rule in the IETU law is not unconstitutional, even though it prevents taxpayers from fully recovering asset tax paid during the prior 10 fiscal years. The Court held that taxpayers cannot claim to have acquired a right to recover asset tax paid until they meet the relevant requirement in the asset tax law, i.e. having an income tax liability in excess of the asset tax liability for the year. The Court also ruled that applying this limitation to the recovery of the asset tax is not disproportionate because simply having paid asset tax within the last 10 years does not give rise to the recovery of the tax and, therefore, its limitation in the IETU law does not affect the economic capabilities of the taxpayer to pay IETU.


Conclusion

It is disheartening that the Supreme Court has missed yet another opportunity to curtail the Mexican government´s ability to create new taxes that bear no relation to the economic circumstances of the country. Of greatest concern is that the Supreme Court uses simple and, in some cases, an inaccurate technical analysis to support conclusions that, when fully analyzed, create an impression that the conclusion was reached before the analysis, and the analysis was made simply to support the conclusion.

Taxpayers are faced with an uncertain outcome regarding the possibility to challenge the seemingly unlimited power of the government to tax in any way it sees fit, with minimal regard to the constitutional rights to be taxed in a proportionate, legal and equitable manner. We will need to wait and see how the Supreme Court handles the amparo lawsuits against the recent reform of the tax consolidation regime which, among other features, retroactively taxes consolidated groups.