According to officials at Mexico's Tax Administration Service and Ministry of Finance and Public Credit, since 2014 they have identified more than 8,000 taxpayers who issued invoices for sham transactions that represent a loss for the federal treasury of more than 345 billion pesos.1

While implementing legal measures to close the loop for fraudulent or sham tax transactions is of the utmost importance, a legal amendment recently approved by the Mexican Congress imposes additional administrative and criminal burdens on taxpayers involved in legitimate transactions, resulting in undue economic and financial losses, as well as possible criminal imprisonment.

Surprisingly, a tax crime may be tantamount to participation in organized crime. The legislation, which went into effect on Jan. 1, does not afford clients and customers of blacklisted suppliers a level playing field on which to provide a robust, timely response to an inquiry, or a fair opportunity to demonstrate the substance and/or materiality of past transactions being called into question.

Mexico's Federal Tax Code was amended in 2014 to give its taxing authority the power to deem that a given activity is a sham transaction for tax purposes if any of the following two events occurred:

  • The taxing authority is unable to locate the taxpayer in its tax domicile upon a verification inspection; or
  • The taxpayer fails to maintain proper and sufficient documentation, and information showing it had the assets, resources and material capacity, infrastructure, or personnel to support the sale of goods or services indicated on the corresponding invoices.

Mexico's Federal Tax Code requires the taxing authority to serve a seller or service provider with formal notice before opening an investigation into alleged sham transactions. This allows the seller and/or service supplier an opportunity to rebut the allegations.

However, the tax code does not require that any notice be served on buyers or service recipients who claimed a tax deduction or value added tax credit related to the transactions under investigation.

If upon the conclusion of an investigation by the taking authority the seller or service supplier is found to have issued sham invoices or reported sham transactions, the taxing authority publishes their name and taxpayer ID number in the Federal Official Gazette, thereby blacklisting the seller or supplier. No additional notice of the blacklisting is issued to buyers or service recipients.

Once published, the finding is binding and impacts anyone who claimed a tax deduction or VAT credit for an invoice issued by the blacklisted taxpayer. The finding is retroactive.

The effect is to render null and void any deduction or VAT credit claimed by a customer for an invoice issued by the now blacklisted supplier during the preceding five years (the term equivalent to the prevailing statute of limitations). It also creates a presumption that the customer's filings were based on sham transactions.

Many taxpayers have suffered financial losses after purchasing goods or retaining the services of a supplier that had been blacklisted. In the majority of such cases, the taxpayer was penalized simply because they could not overcome the taxing authority's presumption that they knowingly participated in sham transaction or because the blacklisted supplier was out of business.

According to the tax code, a taxpayer who has received invoices from a blacklisted supplier has 30 business days from publication in the gazette to rebut the presumption that it participated in a sham transaction by filing information and documentation that shows that invoiced goods or services claimed were actually acquired. Such term does not admit any extension. Considering that the official blacklist of taxpayers is updated frequently, and that no personal notice is given to clients of newly blacklisted entities, it is common that such clients are unaware of the situation, and are therefore unable to present evidence rebutting the presumption of having participated in a tax sham transaction within the 30-day term.

Taxpayers who fail to rebut the presumption are required to:

  • Cancel any claimed income tax deduction and pay the resulting applicable income tax at the 30% statutory rate;
  • Reimburse any corresponding credited input VAT, which is the VAT shifted by suppliers of goods or services onto customers. The regular rate is 16% over the value of the transaction. For example, if a company renders a service, it will shift 16% of VAT to its customer. The 16% VAT is an output VAT for the service provider and a 16% input VAT for the service recipient.
  • Pay any corresponding adjustments for inflation, interest and other penalties corresponding to the income tax and VAT. The interest is equivalent to 1.47% of the unpaid tax, calculated on a monthly basis (17.64% on a yearly basis); and
  • If applicable, increase the amount paid into an employee mandatory profit-sharing plan, determined by the year-end tax result and not based on financial results.

Additional Consequences for the Recipient of Sham Invoices

Under the tax reform that went into effect on Jan. 1, failure to present evidence that an affected transaction was not a sham within the 30-day rebuttal term, may also have the following effect:

  • Cancellation of the tax certificate for the electronic tax signature of the taxpayer company, rendering the company unable to file tax returns and complete other official tax filings electronically
  • Cancellation of the electronic seal required to issue tax invoices to clients, tax withholding certificates to suppliers and electronic payroll tax stubs to employees
  • Suspension of the registration of the taxpayer company with the importer's registry
  • If applicable, suspension of the certification of the taxpayer company for VAT purposes (required to avoid VAT cash disbursements on temporary imports)
  • Reversal of any tax benefits or incentives granted by municipal, state or federal governments
  • Joint personal liability of general directors, general managers and sole managers of the taxpayer company for any tax deduction supported with a sham tax invoice
  • Prohibition from participating in any bidding process or other type of contracts with the Mexican government

Other administrative and economic fines and sanctions may also be assessed.

Relevant Aspects of the Labor Subcontract Regime

In addition to the above, several labor and tax implications are associated with the reception of services by a given taxpayer. The origin of all such legal implications is the labor subcontract regime, which is now being used by the tax authority to evaluate the substance of a contractual relationship where personnel is made available to a service recipient, and to determine whether or not such a relationship is an employment relationship rather than a company service relationship.

The relationship determination has implications on expense deductions for income tax purposes, and on claiming a tax credit for the VAT shifted by the service provider.

The labor subcontract regime was promulgated in December 2012, in Article 15-A of the Federal Labor Law, with the enactment of specific conditions under which the recipient of services shall not be considered in an employment relationship with workers of a service provider.

However, Mexico's federal labor courts have not issued binding resolutions or precedents regarding the analysis of the subcontracting regime.

The labor subcontract regime has only been scrutinized by the taxing authority in an effort to prevent aggressive structures aimed at eroding the tax base for salary and wage payments, and at undue crediting of VAT shifted by service providers.

The taxing authority has been successful in characterizing certain service contracts as labor subcontracting, with a direct labor relationship of the workers/employees with the service recipient, in order to deny the crediting of VAT and reject income tax deductions.

In 2017, the income tax law and the VAT law were amended to include a requirement that certain documents be maintained by a service recipient to confirm that its service provider complied with a minimum standard from a tax standpoint.

These legal reforms shifted the burden of maintaining large files of tax and labor documents from the service provider to the service recipient and created additional uncertainty for taxpayers.

In light of such tax and labor uncertainty, the taxing authority issued a software application, designed to allow the service recipient to validate service providers' tax compliance. However, the application only was valid from 2017 until August 2019, when it was repealed by the taxing authority and the new governmental administration.

This again created uncertainty for taxpayers about the level and type of documentation that a service recipient needed to maintain — about the nature of the service provided (whether it was outsourcing, insourcing or something else), how such services were received, and the scope of business activities of the service recipient — in order to claim a tax deduction and VAT credit for services received.

Currently at least seven initiatives have been submitted before Mexico's Congress to amend the concept of "labor subcontract" in the federal labor law.

In general terms, these initiatives have the purpose of limiting the current subcontract regime in order to restrict the type of activities that may be subcontracted and the duration of the term for the subcontract of services.

Moreover, on Aug. 13, 2019, the Unit of Financial Intelligence of the Mexican Social Security Institute, or IMSS, and the Ministry of Labor entered into an agreement for the exchange of information, with the purpose of making their auditing efforts more efficient and combating corruption. The agreement lists subcontracting of services as a vulnerable activity to be reported for anti-money laundering purposes.

The 2020 tax reform includes other substantial changes with respect to the payment of VAT. The provisions that went into force on Jan. 1 provide that whenever a service is rendered to personnel of a service recipient, the service recipient must partially withhold the VAT shifted by the service provider, regardless of whether or not the service is a specialized service, a subcontract service or some other type of service.

Specifically, from the 16% VAT triggered by the service provider and shifted to the service recipient, an amount equivalent to the 6% VAT shall be withheld by the service recipient to be paid directly to the tax authority, and the remaining amount equivalent to the 10% VAT would continue to be paid by the service recipient to the service provider.

Moreover, the income tax law was also amended to include a provision specifying that whenever the service recipient fails to withhold the VAT, or any other tax, the service recipient may not claim a tax deduction for the paid services.

However, and although the wording of the new provision of the VAT law creates uncertainty by indicating that the services are rendered through having "personnel at the disposal of the service recipient," it is advisable from a tax standpoint to withhold the VAT rather than risk having a disallowed tax deduction, and safeguard the claim of the VAT credit.

This reform creates an additional need for maintaining sufficient documentation to evidence the proper withholding or nonwithholding of VAT on services received, segregating those services that are subject to VAT withholding from services where there is no VAT withholding. Otherwise companies may be vulnerable to rejection of income tax deductions and the VAT credit.

Taking into account the implications of the past, current and foreseeable labor and tax environment, it is advisable for each company to analyze the scope and reach of the services they receive.

Companies need to determine the type of documents they should maintain to evidence not only the actual reception of services from a current or potential blacklisted service provider, but also to evidence the correct level of compliance with respect to VAT withholding in order to claim the VAT credit and income tax deduction related to the expense for services.

Criminal Implications

The grounds for criminally prosecuting taxpayers involved in transactions with blacklisted entities or individuals have been increasing.

The criminal implications of receiving sham invoices from blacklisted suppliers are regulated in the Federal Tax Code and, recently, were included in the proposed Federal Law Against Organized Crime, which considers such activities tantamount to crimes such as kidnapping, drug trafficking, terrorism, gun trafficking, human organs trafficking, etc.

Specifically, there are four different types of crime that may result in imprisonment of legal and commercial representatives of the buyer, as well as the legal entity, which may be summarized as follows:

  • Receiving invoices from a blacklisted supplier, regardless of the amount of the alleged sham invoices, is a crime subject to imprisonment for three months to six years2
  • Giving a tax effect to invoices issued by a blacklisted supplier is a crime subject to imprisonment for three months to nine years3
  • Participating in the reception of invoices from a blacklisted supplier when the aggregate totals are $7,804,230 Mexican pesos (approximately USD 400,000) in a given fiscal year is a crime subject to imprisonment from four and up to 16 years4
  • Failing to demonstrate the substance or materiality of the transactions a company had with a blacklisted supplier. Regardless of a self-correction and spontaneous tax payment, the legal entity may be subject to criminal prosecution, which may result in any of the following sanctions:5
    • Suspension of activities of the company (for six months to six years)
    • Closure of branches
    • Prohibition to undertake activities related to the one that resulted in the crime (for six months to 10 years)
    • Imposed judicial receivership to protect the rights and benefits of workers and suppliers
    • Liquidation of the legal entity

Possible Actions to Take

The current mechanism for blacklisting taxpayers has been supported by unanimous criteria in different court precedents and jurisprudence and is based on past performance. This trend is expected to continue throughout Mexico, despite the unfair lack of notice to customers and clients of newly-blacklisted suppliers.

Considering the unfavorable tax and criminal environment for the clients of blacklisted suppliers, companies should mitigate the tax and criminal risk of incurring inadvertent sham transactions by implementing more robust internal controls and compliance protocols. Start with the review of existing contracts, purchase orders and other means of documenting commercial relationships with different suppliers, in an effort to identify areas of liability and burden of proof that may be shifted onto such suppliers.

Moreover, as part of the review process, segregate suppliers into three different categories as follows:

  • Suppliers of goods being profiled by the taxing authority as at high risk of tax fraud (i.e. steel, aluminum, other metals, scrap goods or materials, and other goods that are being profiled)
  • Suppliers of all services received by the company, whether they are specialized services, in-sourced services, outsourced services or other types of services. The service sector is another one characterized by the taxing authority as at high risk for tax evasion, and special attention should be given to the labor subcontract regime and applicable VAT treatment
  • For all other suppliers, at least a random review should be undertaken to confirm that the company has in place the means to eventually demonstrate the reception of purchase goods or the cost of goods sold concept (beyond tax or financial record keeping, maintaining documents such as bill of lading, cargo receipt acknowledgement, logs and other information pertaining the entire chain of value of the transactions, among others).

As part of the review, companies should identify current procurement procedures and best practices that may be implemented, as well as determine the de minimis standard of documentation that the company must maintain to demonstrate, if necessary, the substance or materiality of transactions.

Thus, companies should create a system of records maintenance, available to document its reception of goods and services, as well as a protocol to provide such information and documentation to the taxing authority whenever a given supplier is blacklisted.

Although individuals involved in a criminal prosecution of transactions characterized as organized crime will not have the possibility of posting a bond (imprisonment will be mandatory), by improving the standard of record keeping, the likelihood of avoiding criminal prosecution and ultimately resulting in the liberation of the involved individuals will be greater.

Finally, due to the lack of proper personal notice to the service recipient about the alleged involvement in a sham tax transaction, in order to mitigate the tax, financial and criminal risk, it is advisable to develop, either internally or through a vendor, a software system that cross references the list of current and past (going back at least five years) suppliers of goods and services with the taxing authority's blacklist on a daily basis, and to implement a standardized mechanism for decisively presenting the supporting evidence to the taxing authority.

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1 Ratio legis explanation, the rationale or motive behind a law, of the tax bill proposal passed by the Mexican Congress to amend the Mexican Federal Tax Code, the Federal Criminal Law and the Federal Law against Organized Crime.

2 Penalty under Article 113 of the Mexican Federal Tax Code, as amended on September 2019. This criminal count must be prosecuted to the extent that the facts related to the criminal activity are not rebutted. However, prosecution will not be pursued when the applicable taxes and levies are spontaneously paid prior to a tax inspection or formal prosecution of the criminal count.

3 Penalty under Articles 109 and 108 of the Mexican Federal Tax Code. Please note that for this criminal count cannot be prosecuted against the buyer if such recipient of the invoices from the blacklisted supplier spontaneously undertakes a self-correction with the payment of the applicable taxes prior to a formal notification from the taxing authority.

4 Article 4 (II) of the Federal Law against Organized Crime in effect as of Nov. 9, 2019. Under this count, the holder of the tax electronic signature of the company, the head of the payables accounts and the head of procurement department would be equally liable, among others, as they may be deemed to have participated and agreed in the undertaking of a crime.

5 Please note that individuals who acted in representation of the company may as well be subject to criminal prosecution.

 

* Luis C. Carbajo and Juan Carlos Valles Zavala are partners at Baker McKenzie.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firms, their clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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