Pedro Ángel Palma Cruz
Sanchez Devanny Eseverri, Mexico City
ppalma@sanchezdevanny.com

Yamile Pérez-Moreno Chiapa
Sanchez Devanny Eseverri, Mexico City
yperez@sanchezdevanny.com

Should the term ‘business profits’ be defined under domestic law? Mexico and the denial of treaty benefits to foreign residents

Article 7(1) of the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention provides that the profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in the other contracting state through a permanent establishment situated therein.^[1] Furthermore, the Commentaries to the OECD Model Tax Convention provide that the term ‘profits’ has a broad meaning, including all income derived in by carrying on an enterprise.^[2] 

Despite these provisions, the Tax Administration Service (Servicio de Administración Tributaria or SAT) considers that tax treaties should precisely define the term ‘business profits’ contained under Article 7 of the different tax treaties duly signed by Mexico, and should follow the OECD model. Instead, the treaties construe the term ‘business profits’ under domestic law, leading to the denial of treaty benefits (‘business profits’) to foreign residents. Even more worrisome, federal tax courts have supported this interpretation several times, resulting in double taxation due to a deficient interpretation.

As mentioned earlier, SAT considers that the term ‘business profits’ should be defined under the Tax Convention. Therefore, to the extent it is not (despite the fact that they could use OECD commentaries to define profits in its broad sense), SAT uses Article 3(2) where any term not defined under the Tax Convention shall, unless the context otherwise requires or the competent authorities agree to a different meaning, have the meaning that it has at that time under the law of that state for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that state prevailing over a meaning given to the term under other laws of that state.^[3]

Accordingly, domestic tax law expressly excludes from the term ‘business activities’ any type of income derived by foreign residents from Mexican sources.^[4] In other words, ‘business activities’ do not include any income received by foreign residents from Mexican sources, including the common activities considered under Article 7 of the OECD Model Tax Convention, such as:

• technical assistance;
• independent personal services (if the treaty lacks Article 14);
• advertising; and
• in general any service rendered by foreign residents in Mexico.

To square the circle, SAT has issued the Administrative Miscellaneous Regulations to interpret that ‘business profits’ contained under Mexican tax treaties under Article 7 are covered by the term ‘business activities’ in Mexican law. Based on this set of regulations, the SAT overrides treaty obligations (business profits) by imposing the domestic law’s definition of ‘business activities’, where all income sourced to Mexico is not considered therein.

The practical result is that Mexican tax residents apply domestic law withholding taxes (generally 25 per cent) regardless of the treaty benefit of taxing business profits generated by foreign residents in the residence state if the enterprise is not carried on through a permanent establishment in Mexico. 

The situation can worsen if Mexican taxpayers do not withhold the domestic tax rate (generally 25 per cent) to the extent that any expense should meet the Mexican domestic law requirements. In the case of payments to foreign residents, Mexican taxpayers should prove that they apply correctly the withholding tax (domestic or treaty withholding tax), which from the Mexican tax authority’s perspective should be the domestic law withholding tax (generally 25 per cent), instead of permitting the other contracting state (residence state) to tax said business profit, leading not only to double taxation but also to the deduction denial of the expense. 

The interpretation mentioned above has led Mexican taxpayers to withhold and pay the higher domestic law withholding tax (generally 25 per cent) to protect their deduction expense (regardless of the Article 7 applicability), sometimes supporting their position in another domestic law disposition that provides for foreign taxpayers to access the treaty benefit through an income refund requesting the difference between the domestic withholding tax rate and the treaty benefit from SAT. This is something that, in practice, is not likely to occur. 

On the other hand, one could think that specialised courts should make some sense of this awful situation. Unfortunately, federal tax courts have supported on various occasions the SAT’s interpretation of the term ‘business profits,’ leaving taxpayers with double taxation and no deduction for the expense, regardless of the domestic rules providing that foreign taxpayers could access treaty benefits through an income refund that is not likely to happen. 

Last but not least, the recommendation is to seek a mutual agreement procedure (MAP) to alleviate the double taxation situation, expecting that a foreign tax authority could help SAT to understand that the term ‘business profits’ should not be defined. In this case, we are talking of a treaty-independent term which, as mentioned by the OECD commentaries, is so broad as to cover all ‘profits’ carried by an enterprise. Suppose both authorities reach a consensus and adequately interpret that business profits should be taxed in the residence state. In that case, the deduction expense should also be protected regardless of being a merely domestic law issue. 

In any event, think twice when applying a business profits disposition with Mexico and seek advice before getting into an awful situation such as the one described herein.