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Berdeja y Asociados, S.C.
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Av. Prolongación P. de la Reforma 61-4º B
Col. Paseo de las Lomas
01330 México, D.F.
Tel: (52-55) 2591-1100 Fax: (52-55) 2591-1106
e-mail: berdelaw@berdelaw.com

December 24, 2004

M E M O R A N D U M

“THIN CAPITALIZATION RULES IN MEXICO: A PREMIER”

For the first time in the history of the country, the United MexicanStates (“Mexico”) is adopting thin capitalization rules.

I. INTRODUCTION

There are two basic ways in which a company can finance its operations, i.e. through debt or equity. When a company is financed through debt, whether through loans, bonds, or similar, it may have to pay interest to the lender, bondholder, etc. Generally, taxpayers are entitled to deduct interest payments. However, in orderto limit the deductibility of interest and/or penalize excessive levels of debt which could facilitate tax evasion or at least a considerable reduction of the tax basis, some countries enact rules which are known worldwide as “thin capitalization rules”. Many members of the Organisation for Economic Co-Operation and Development (Organización para la Cooperación y el Desarrollo Económico) (“OECD”)and other European and Latin American countries i.e. Argentina, Peru and Chile,[1]/ have adopted thin capitalization rules. These rules vary from country to country.[2]/

Many companies prefer to obtain financing through debt because it implies tax benefits. While interest derives from debt, dividends derive from equity. Accordingly, interest may be deductible and dividends are generallynon-deductible. In some jurisdictions dividends may lead to double taxation, whereas interest is generally taxed once at the recipient level. Usually, withholding tax rates on interest are lower than those applicable to dividends or distribution of profits.

II. THIN CAPITALIZATION RULES IN OTHER COUNTRIES

The OECD Council adopted a “Thin Capitalisation Report” in 1986.[3]/ Such reportinfluenced domestic legislation of various countries as well as the drafting of the commentaries on the articles of the OECD’s Model Tax Convention on Income and on Capital (Modelo de Convenio para evitar la doble imposición e impedir la evasión fiscal) (“MTC”).

Thin capitalization rules restrict the deductibility of interest. Most countries which adopted these rules restrict interest deduction,provided that an entity’s debt-equity ratio exceeds a certain threshold. Many countries in which thin capitalization rules are in force limit their application to foreign related-party transactions.[4]/ The debt-equity ratio ranges from 1:1 to 1:7[5]/ depending on the domestic tax laws of each country. In addition, other countries have adopted rules which deal with specific cases instead of setting aspecific debt-equity ratio. For instance, loans granted by a director, by an executive officer who is a shareholder, by a company located in a tax haven may give rise to a limitation on interest deduction.[6]/

Finally, the definition of “debt” for thin capitalization purposes, where it exists, is not always uniform.

III. CRITERION OF THE TAX ADMINISTRATION SERVICE (SERVICIODE ADMINISTRACIÓN TRIBUTARIA) (“SAT”) ABOUT THIN CAPITALIZATION

Even though Mexico is a OECD member, thin capitalization rules had never been legally adopted. However, in May 2004 the SAT published in its website a series of guidelines or criteria describing “unlawful tax practices”. Among them, there were guidelines on thin capitalization. These guidelines or criteria are not legally bindingsince they were not based on any law or regulation. This notwithstanding, the adoption by SAT of thin capitalization rules showed the position of Mexican tax authorities. These rules were finally enacted by way of amendments to the tax laws for 2005.

The SAT’s thin capitalization rules are the following:

“If an entity exceeds the debt-equity ratio of 3:1 or 6:1 in case of...