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Business Flat Tax (IETU)

Introduction As described in the Preamble for the Bill submitted to Congress by the Executive Branch introducing the business flat tax, for decades, Mexico's Public sector financing has depended on petroleum exports. In most cases, Government's planning has been carried out based on the price per barrel of this natural resource. The premise is simple: the higher the price, the higher the expenditures that can be allowed. Even though this situation has worked to sustain our economy in the past, nowadays it is imperative to change such dependence. Besides the risk of letting stability depend on market conditions, the urgency of finding a solution to this problem also responds to the need of allowing Petroleos Mexicanos (or PEMEX, the Mexican decentralized organism in charge of the central direction and strategic management of all activities related to the petroleum industry in the country) invest in investigation, petroleum research, and production capacity, in order to guarantee its own growth and development. We cannot expect to have a first class company in the future if a significant amount of its profits are oriented to cover Government expenditures. However, finding a solution to this problem is not an easy task. There is a general acceptance that Mexico's growth should not be dependent on the petroleum's performance in the market, and that any possible solution should neither increase taxes nor affect those who are already paying them properly. Then, the answer seems to be in increasing tax collection, as well as in a better distribution of tax burden amongst taxpayers. Considering the above, on June 2007, the Executive branch headed by President Felipe Calderón, sent a bill to Congress, which included, among others, a new flat tax (known in the beginning as contribución empresarial a tasa única). After the corresponding legislative process, by means of which certain technical adjustments and amendments were made to the bill, on September 2007, Congress approved in general and in particular this new flat tax (which name was modified to impuesto empresarial a tasa única, or IETU, per its initials in Spanish). Then, on October 2007, the IETU Law was published on the Official Gazette, and it came into effect on January 1, 2008. Such tax intends to be a minimum tax complementary to income tax; therefore, asset tax was repealed starting tax year 2008. Acting as a minimum tax, and with the possibility of replacing income tax in the future, this new tax intends to improve the government's tax collection by broadening the number of taxpayers. This new tax is an issue of great concern for Mexican tax policy, mainly, because it is unclear whether it would be able to achieve the objective mentioned above. First, it seems that it will increase the tax burden of taxpayers who have been paying taxes properly, instead of actually increasing the number of taxpayers. Also, there is a risk that such tax may lower Mexico's competitive position, as it may discourage investments. Moreover, it has been said that Government collection goals with IETU are not enough to meet the country's current needs.

-2Unfortunately, it seems that once more we are faced with a tax reform that, despite its objective, is far from being an overhauling of the Mexican tax system that is really required. Considering all of the above, in this article we analyze the general aspects of the IETU regime, as well as the main tax implications of the newly enacted tax and the regulation issued through the Presidential Decrees published on November 5, 2007 and February 27, 2008 which provide transitional rules for the enactment of the business flat tax and additional benefits for certain taxpayers (i.e.: REIT's and real estate investment companies), respectively. IETU tax regime General aspects In accordance with the Preamble that was submitted to Congress by the Executive branch, the purpose of this tax is to impose a tax burden with a broader base than that of income tax, as it was mentioned before. As previously mentioned, IETU was established as a minimum tax with respect to income tax; this means that IETU will be only be payable when said tax is larger than income tax, and up to the amount of the difference between such taxes, however, unfortunately it doesn't in fact work as a minimum tax (like asset tax did), since IETU paid is not recoverable in the future whenever income tax is higher than IETU, thus becoming a final tax and not a minimum tax. This issue has made Mexico's commercial partners question whether or not it is a tax "similar" to income tax, and thus creditable abroad and included within the scope of Conventions for the avoidance of double taxation and the prevention of fiscal evasion. In fact, the Internal Revenue Service, through Notice-2008-03 has provided that, pending outcome of a study to determine whether the IETU is a creditable income tax, the IRS will not challenge a taxpayer's position that the IETU is an income tax that is eligible for a credit under Article 24(1) of the U.S.-Mexico income tax treaty. The specific wording of the aforementioned Notice, is as follows: "...the IRS and the Treasury Department believe that the provisions, design, and full operation of the IETU, including its interaction with Mexico's regular income tax, require study to determine whether it is a creditable income tax. Pending the conclusion of this study, the IRS will not challenge a taxpayer´s position that the IETU is an income tax that is eligible for a credit under Article 24(1) of the Treaty. This Notice is effective for the IETU paid or accrued on or after January 1, 2008. Any change in the foreign tax credit treatment of the IETU as a result of the study will be prospective, and apply solely to the IETU paid or accrued in taxable years beginning after the date that further guidance is issued". .. Other countries have clarified their positions in this sense, concluding that it is creditable and similar to income tax (i.e. Germany, Canada, Spain, Netherlands, among many others).

Taxable activities It is established that Mexican resident individuals and legal entities, as well as

-3non-residents with a permanent establishment in Mexico, are obliged to pay this tax on income they realize, regardless of the place from which it originates, as a result of the performance of the following activities: i) ii) Sale or disposition of property; Rendering of independent services; and

iii) Granting of the temporary use or enjoyment of property. As it can be seen, taxable activities are basically those defined as such in the Value Added Tax Law. In general terms, IETU is determined by applying the rate of 17.5% to the result obtained by deducting from income realized during the period as a result of the performance of taxable activities, the deductions authorized by the law. 1 IETU is determined considering income and deductions on a cash flow basis (as in the case of value added tax); that is, aggregate income will be taxable and expenditures will be deductible at the time of actual collection or payment, as applicable. Activities not within the scope of IETU Among others, the following items do not fall within the scope of this tax: i) ii) iii) iv) v) the temporary use or enjoyment of property between Mexican resident or nonresident related parties that gives rise to the payment of royalties; financing or loan transactions that give rise to the payment of interest that are not considered as part of the price; financial derivative transactions when the sale or disposition of the underlying property is not subject to the IETU Law; gains on the sale of shares, notes receivable or other credit instruments; and dividends Royalties

In the specific case of royalties, it is inferred that only royalty payments between independent parties shall be subject to this tax. For this purpose, the definition of related parties is the same as that set forth in the Mexican Income Tax Law. The Opinion Report of the Finance Committee explains that this limitation was included because it has been detected that royalty payments are utilized as a means for reducing the taxable basis of income tax when they derive from transactions carried out between related parties, situation that would also occur in the case of IETU. The limitation mentioned above is questionable, as there is no justification to legislate by exception with the purpose of generating tax revenue, since this circumstance will affect the competitiveness of Mexico in respect of countries where the deduction of this type of

Through a transitional provision of the IETU Law, it is established that for 2008, the applicable tax rate will be 16.5% and for 2009, it will be 17%.


-4payments is allowed and will harm the performance of legitimate business where no tax benefit is pursued. - Financing operations The Opinion Report of the Finance Committee provides that since for purposes of IETU, investments are deductible at the time they are carried out, instead of depreciating them overtime (as for income tax purposes), there is an economic effect equivalent to deducting, in addition to the amount of the investment, interest paid on the financing for acquiring such investments, which is why it is indicated that it would be inexact to assert that IETU does not allow the deduction of interest. Such justification is partially true, because the discount rate that would be utilized to determine the present value of the depreciation deduction is not necessarily equivalent to the rate applicable to financing obtained to acquire the property. Furthermore, in many instances the related financing is not utilized for the acquisition of property but for other purposes, such as working capital. Taxable income For purposes of calculation the basis of IETU, the following items are part of taxable income: a) The price or consideration obtained as a result of the performance of taxable activities; b) The amounts collected from or charged to the acquirer as taxes (except those shifted under the terms of the applicable provisions), fees for Government services, regular or past due interest and contractual penalties; c) Advanced payments and deposits. In the event that the price or consideration for taxable activities is not collected in cash or check, but wholly or partially in other property or services, the market value thereof would be taken into consideration, or in absence thereof, the appraisal value of such property or services, would be deemed taxable income. Furthermore, in the absence of a consideration, the aforementioned values that correspond to the property sold or services rendered would be utilized for purposes of the calculation of the IETU. Deductions Taxpayers of IETU may claim the deduction of disbursements made for the acquisition of property, independent services rendered or the temporary use or enjoyment of property utilized for the performance of their taxable activities, or for the administration of these activities, provided that they generate income subject to the payment of this tax. Consequently, taxpayers of IETU may deduct any expenditures that are related to income subject to this tax, including, among others, administrative expenses, rents, and electric power. In general, authorized deductions shall meet, among others, the following

-5requirements: a) they shall correspond to taxable acts for purposes of this tax on the part of the seller or the provider of the service; b) they shall be strictly indispensable; c) they shall be actually paid; d) they shall comply with all the other requirements of the Mexican Income Tax Law. Furthermore, taxpayers of IETU will be able to consider as authorized deductions, among other items, their tax liabilities (exception made of income tax, IETU, tax on cash deposits, social security contributions, as well as taxes that must be shifted in accordance with the tax laws), non-onerous or non-compensatory donations with the restrictions set forth in the Mexican Income Tax Law, as well as losses from uncollectible loans. It is worth mentioning that salaries, wages and social security contributions payable by the employer, even though not deductible for the determination of IETU, generate a credit against this tax, as it will be discussed below. - Investments from September through December 2007 The IETU Law provides the possibility of claiming an additional deduction for expenditures actually incurred in the acquisition of new investments in the last four-month period of 2007 that are deductible for purposes of IETU, up to the amount of the consideration actually paid for such investments in that period. The deduction of these expenditures must be carried out in three fiscal years beginning in 2008 until fully deducted, by applying a third portion in each fiscal year, restated for inflation. For these purposes, the definition of investments is the same as that set forth in the Mexican Income Tax Law. Aditionally, new investments should be understood as those utilized for the first time in Mexico. Unfortunately, this investment deduction does not apply to new investments made before September 1, 2007, nor does it apply to those that do not qualify as new, even when acquired in the last four-month period of that year. The foregoing is critical, specially when taxpayers sell or dispose of such investments, since there will be no recognition of the cost pending to be deducted and will only be allowed to apply certain investements credit (which will be described below), like the one that will be available only in the case of specified investments up to a certain percentage, thus not recognizing the taxpayers' real capacity to bear the tax burden. Credits Once IETU has been determined (taxable income less authorized deductions, multipied by the corrersponding tax rate), the IETU Law, and a Presidential Decree that was published on the Official Gazette on November 5, 2007, provide the possibility for taxpayers to take certain credits against said tax liability. Such credits are: IETU credit, payroll credit, investments credit, paid income tax credit, and inventories credit.


- IETU credit The IETU Law provides that when authorized deductions exceed the amount of taxable income, taxpayers will be allowed to take a credit for such loss. The credit will be for the amount of the difference multiplied by the applicable tax rate. The taxpayer can claim this credit against IETU of that tax year and that of the following ten tax years until exhausted. The only exception to this rule is if the taxpayer has concession with property of public domain or if it renders public services, in which case the credit can be claimed throughout the duration of the concession. If a taxpayer does not claim the credit in a tax year in which it could have been used, it loses the right to claim it in subsequent tax years up to the amount of the credit that could have been used. Furthermore, this credit can be claimed against the payable income tax of the tax year, and the amount used against income tax could not be used against IETU in further years, nor is it refundable. However, it is important to mention that this credit is the only one that can be taken against income tax of the tax year generated, as other credits can only be deducted from IETU on the year they were generated. - Payroll credit Against the difference payable, once IETU credit has been claimed, taxpayers will be entitled to claim a credit which will be obtained by multiplying social security contributions due in the tax year and the taxable income that is used as basis of the income tax computation of each person earning income from salaries and in general for the rendering of a personal subordinated service, by the rate of 17.5% (16.5% in 2008 and 0.17% in 2009), with the object of compensating the effect derived from the non-deduction of said concepts in computing the basis. In order to be able to claim this credit, taxpayers must remit income tax withheld on salaries and in general for the rendering of a subordinated personal service, and they need to deliver to the employees entitled to the subsidy for employment, the applicable amounts in accordance with such subsidy. In my opinion, the salaries, wages and related contributions credit should had been granted as a deduction, since if such credit is not utilized in the fiscal year in which it was generated, taxpayers will forfeit the right to utilize it in subsequent fiscal years. Had such credit been granted as a deduction, and a IETU credit were generated as a consequence of such hypothetic deduction, any amount not used in the tax year could have been carried forward for the subsequent ten years. - Credit for investments acquired from 1998 to 2007 In accordance with Transitional Provisions of the IETU Law, taxpayers that made investments between January 1, 1998 and December 31, 2007, are allowed to claim a credit for against IETU at the annual rate of 5%, over a ten-year period. Such credit is obtained by multiplying the undepreciated balance of each investment by the applicable tax rate for the year.


It is important to mention that the credit for investments cannot exceed the amount of IETU, and those taxpayers that determine a IETU liability lower than this credit, will not be entitled to apply the remaining amount in subsequent years. This tax credit should be claimed annually before the credit corresponding to income tax liability. - Income tax credit Against the net amount determined after the aforementioned credits are claimed, taxpayers will be entitled to credit an amount equivalent to the tax year's income tax liability. The taxpayer's income tax liability available for credit will be the amount of income tax actually paid in accordance with the terms of the respective law; however, income tax paid through credits or reductions carried out in accordance tax provisions, such as the application of tax incentives or preferential treatments available to specific taxpayers, cannot be credited. This limitation may cause that taxpayers entitled to income tax credits or to a tax incentive end up paying IETU, even in those cases in which the income tax liability originally determined exceeds the IETU before the application of the credits or tax incentives previously referred to. This implies that these tax incentives will no longer benefit the taxpayer. Transitional rules for the enactment of the business flat tax - Inventories credit Through a Presidential Decree published in the Official Daily of the Federation, on November 5, 2007, it is provided that taxpayers holding inventories of raw materials, semifinished products, manufactured products or merchandise as of December 31, 2007, which are deductible for income tax purposes upon their sale, will have the right to claim an inventories credit against IETU. The value of the inventory as of December 31, 2007, shall be multiplied by the applicable IETU rate; the resulting amount would be creditable against IETU over a ten-year period, at an annual rate of 6%. The tax credit so determined may be applied on a yearly basis for the period of up to ten years starting in 2008, and it should be adjusted for inflation. The credit may also be taken pro rat in each of the twelve estimated monthly business flat tax payments, and any remaining balance may be considered in the event the Mexican resident taxpayer is liquidated before the ten year period elapses. Land and constructions in process are considered as merchandise when they were acquired for their future resale as part of the main course of business of the taxpayer. Credit for NOL's generated from 2005 to 2007

A yearly credit system is also granted through the aforementioned Presidential Decree in respect of those net operating losses determined for income tax purposes from year 2005 to 2007, but only if those losses were determined as a result of the one-time depreciation deduction of investments allowed by Mexican income tax law, as well as those determined as a result of the one-time full depreciation deduction election available for the acquisition of land

-8when acquired, to the extent such assets continue to be owned by the taxpayer as of December 2007. The additional credit determined as provided by the Decree is available for a period of up to ten years (starting in year 2008). The amount of the yearly credit shall equal 5% of the balance of the "adjusted net operating losses" generated in 2005, 2006 and 2007, multiplied by the business flat tax rate applicable in each year. In general terms, the "adjusted net operating losses" should be determined by the lesser of (i) reported loss and (ii) the sum of the one-time depreciation deduction applied for investments (net of the theoretical ordinary straight-line depreciation of such assets) plus the one-time full deduction applied for the acquisition of land, in order to determine the credit only on the amount of the aforementioned deductions, and only to the extent such losses continue to be available to reduced future income as of December 2007 (losses incurred but already used to reduce taxable income for years 2006 and 2007 should also be eliminated). The credit may be determined on a yearly basis for a period of up to ten years, starting 2008, and it may be adjusted for Mexican inflation. The tax credit may also be taken pro rata in each of the twelve estimated monthly business flat tax payments. In case the asset which acquisition was originally deducted is sold before the end of the aforementioned ten-year period, the taxpayer would not be entitled to use the remaining portion of the credit related to such asset, except in the case of land. Additional deduction for accounts payable

An additional deduction is granted for those taxpayers who carry out at least 80% of their operations with the general public (i.e.: when no invoices but rather simplified receipts are issued as a result of their operations). The deduction shall be equivalent to the amount of the accounts payable derived from the acquisition of finished products that were effectively paid from November 1st to December 31, 2007, provided the products are no longer included in their inventories as of December 31, 2007. Payments for public concessions

Also through the November 5, 2007 Presidential Decree, the additional deduction provided as a transitional rule under the Business Flat Tax Law for "new investments" made from September 1, 2007 to December 31, 2007, which consists in deducting one third of such investments on a yearly basis starting in year 2008, shall also be applicable in respect of the payments made for Government concessions for the exploitation of public property or for the performance of a concessioned public service. Contributions to REIT's and real estate companies Through a Presidential Decree issued on February 27, 2008, an election is provided for grantors and stockholders that contribute real estate to a REIT or real estate investment company, respectively, to defer for IETU purposes recognition of income arising from the alienation of said property at the time of its contribution. Tax may be deferred until the date on which the related gain is taxable for income tax purposes.

-9Taxpayers will have the right to credit the related income tax paid for the year in which the gain is recognized for purposes of said tax. Advanced payments of real estate companies A tax benefit is granted to real estate investment companies in the consistent of not having to make advanced payments of IETU in order for them to have the same tax treatment available to REIT's in the IETU law. This benefit is granted as of January's advanced payment (due February 17, 2008). In those cases where payment was already been made without taking advantage of said benefit, taxpayers may claim refund of the related amount. Special provisions for the financial system Regarding institutions that belong to the financial system, and persons whose main activity is that of a financial intermediary, the IETU Law provides that the financial intermediation margin applicable to transactions on which interest is paid or collected, shall be deemed as rendering of an independent service, and thus, taxable for the purposes of said law. The financial intermediation margin will be determined by subtracting from accrued interest receivable by the taxpayer, the amount of accrued interest payable. The taxpayer should also add or subtract, as applicable, the monetary position result (REPOMO, per its acronym in Spanish) determined by applying the applicable provisions set forth in the Financial Information Rules (Mexican GAAPs), to which members of the financial system are subject to. In general terms, the Financial Information Rules provide that the REPOMO is born from the fact that there are monetary assets and monetary debts that in an inflationary period lose some of their purchasing power, that at the same time keep their nominal value. The REPOMO is the product of recognizing the effect from the changes in the general level of the prices over the aforementioned monetary entries during a given period. For purposes of the IETU Law, interest deemed as such in accordance with the provisions of the Mexican Income Tax Law will be considered as interest. In the event that the financial intermediation margin determined by the institutions of the financial system in accordance with the provisions of the preceding paragraphs is positive, such margin shall be treated as the rendering of taxable services for purposes of the determination of the basis of the IETU. In contrast, in the event that this margin is negative, the financial institutions will be entitled to deduct such margin from their aggregate income for purposes of the determination of IETU. It should be noticed that in contrast with the general regime set forth for the determination of the IETU, the parties that integrate the financial system shall determine their financial intermediation margin on an accrual basis, not on a cash flow basis, which corresponds to the way in which such institutions recognize their transactions based on accounting rules and applicable regulations. Deduction of the asset tax

- 10 Through the same publication in the Official Gazette by Mexican authorities of the IETU Law, the asset tax was abrogated beginning January 2008. However, taxpayers that were obliged to paid the asset tax can still claim the refund of asset tax actually paid during the past ten tax years, provided the refund of such amounts was not previously claimed or they had lost the right to claim it. This amount is creditable against IETU at an annual rate of 10%. Elimination of income tax In addition to the above, since it the Authority's intent to leave IETU as a single tax and not as a tax complementary of income tax, it is provided that in two years they will review the convenience of eliminating certain chapters of the Income Tax Law (which apply to the same taxpayers of IETU). In my opinion, IETU as a single flat tax would not have been a bad alternative for increasing tax collection and the number of taxpayers, thus strengthening the Government's financing; however, the fact that it coexists with income tax has made it a significant tax burden for many taxpayers, and has definitely complicated the latter's operations and administration. As may be derived from all of the above, the IETU as originally conceived has undergone several adjustments, and in fact, there are still many issues pending to be resolved and regulated, which has made it burdensome, on top of the fact that many taxpayers have elected to file an "amparo" proceeding against it, due to the various issues that make it unconstitutional. A lot is still pending to be resolved. Among others, regulations must be issued, Mexican Tax Courts will have to resolve all the claims filed by taxpayers, and other country's reactions to this tax must be awaited, so this is a new tax that has to be followed up closely to see how it develops in the long run.



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