Eugenio Grageda is Senior Counsel in Holland & Knight's Mexico City office.
As noted in Part 1 of this series of Articles, new H.R. 1, informally known as the Tax Cuts and Jobs Act ("Tax Act"), has been the most important change to the US tax code in a generation. For companies across a variety of sectors the Tax Act has potential implications for both Mexican direct investment into the US and for US direct investment into Mexico. In this Part 2 we continue to address the Tax Act's most important implications in a Mexico - US context.
Mexican Corporations and Individuals with Businesses and Investments in the US - Corporation v. Pass-through A current bigger gap between the new 21% US corporate rate and the 37% rate on pass-through business income (assuming the 20% deduction on pass-through income is not applicable) might affect decisions on whether to run a business through a US pass-through entity or a US corporation. The best alternative will generally depend on the specific circumstances in any given case.
Structure 1: Mexican Corporation or Individual Shareholder with US Subsidiary Corporation
The reduced corporate rate could at first glance incentivize operating in corporate form. However, a second level of tax exists when cash is distributed from a US corporation.
Besides the 21% corporate tax payable by US corporations, a US withholding tax of 30% (generally reduced to 0%, 5% or 10% as the case may be under the Mexico-US Tax Treaty) will apply when such income is distributed as dividends from such US corporation to Mexican shareholders.
This will result in a combined US federal income tax of up to 44.7%2 (21% + 30% (1-0.21)), assuming no reduced treaty rate is available, for Mexican corporate or individual shareholders with respect to a US corporation's income or gain that is distributed to them, as opposed to a 54.5% effective rate under the previous law.
Under this structure, a Mexican corporation should recognize the distributed amount as taxable income in Mexico and pay the corresponding tax at a rate of 30%. In case of Mexican individuals, they should also recognize the income and pay an additional definitive tax of 10% over the dividends received from the US corporation.
The Mexican corporation will generally be able to obtain a foreign tax credit in Mexico for the income taxes paid by the US subsidiary and for the taxes withheld in the US upon a dividend distribution. On the flipside, a Mexican individual shareholder will not be able to credit in Mexico the taxes paid directly by the US subsidiary in the US. Only the taxes withheld in the US.
B. Structure 2: Mexican Corporation with a US Pass-Through entity or Direct Business in the US
Mexican corporations with a US trade or business or, with respect to beneficiaries of the US-Mexico Tax Treaty, a US permanent establishment ("USPE") or Mexican corporations with an interest in a pass-through entity, such as a partnership or a Limited Liability Company ("LLC")3 treated as such, doing business in the US, will be subject to a flat US federal corporate income tax of 21% on such US trade or business income, as opposed to the previous maximum 35% rate.
A Mexican corporation generating business income in the US through a USPE or a pass-through entity is also subject, at year end, to a US "branch profits tax" at a rate of 30% (generally reduced to 0%, 5% or 10% as the case may be under the Mexico-US Tax Treaty) applicable on the Mexican corporation's after-tax US business income, irrespective of distributions. This will result in the same combined US federal income tax rate as in Structure 1 of 44.7%, assuming no treaty rate is available.
If instead, passive income, not effectively connected to a US trade or business, is generated in the US through a US pass-through entity, such entity will not be subject to tax in the US. But the Mexican corporate partner of the same will be subject to a 30% domestic withholding tax on gross US source passive income, reduced or eliminated under certain circumstances under the Mexico-US Tax treaty, and should also generally recognize this income on a current basis, irrespective of any actual distribution, paying income tax at the rate of 30% minus available foreign tax credits, if any.
Structure 3: Mexican Individual with a US Pass-through Entity or Direct Business in the US
Mexican individuals with a USPE or a pass-through entity generating business income will be subject to a US federal income tax at the new graduated tax rates with a maximum rate of 37%, instead of the previous maximum rate of 39.6%.
The additional deduction of up to 20% of "Qualified Business Income" derived by a Mexican individual through pass-through entities engaged in a "Qualified Trade or Business" would in effect reduce that maximum rate down to 29.6% (37% (100%-20%)). Yet, a Mexican individual will be restricted to fully apply such deduction in specific circumstances, e.g. if the business has no sufficient W-2 wages payable to employees or depreciable property, or if the business is not a "Qualified Trade or Business".
On the other hand, if the US pass-through entity earns US source passive income, not effectively connected with a US trade or business, there will be no tax liability in the US at the entity level, but the Mexican individual will be subject to a 30% withholding tax in the US on a gross basis, reduced under certain circumstances under the Mexico-US Tax treaty.
In Mexico, this income should be accumulated by the individual and subject to a tax at the relevant marginal tax rate of maximum 35%, minus available foreign tax credits, if any. In addition, a definitive tax of 10% would apply over the received distributions, except in certain cases where...