What is thin capitalization and why is it important?
Companies are usually financed through a mix of equity and debt. If a company’s financial structure includes a relatively high level of debt in comparison to its equity, it is referred to as thinly capitalized.
The financial structure has an impact on a company´s profit or loss in terms of tax obligations. The higher the level of debt, the higher the amount of interest which can be deducted. As this affects a company’s tax base, many countries implemented rules to limit the deductibility of interests.
What are the thin capitalization rules in Mexico?
Art. 28 LISR Paragraph XXVII: The deductibility of interest expenses made by a company on a loan of a nonresident related party is limited for tax purposes if its debt to equity ratio exceeds 3:1.
The debt to equity ratio is determined based on average amounts. To calculate the average equity of a company the balance of the equity of the first and last day of the tax year is summed up and divided by 2.
Please note that there are two equity key figures which can be used for the calculation: the CUCA or the sum of CUCA and CUFIN. Once applied, the same option must be used for at least five consecutive years.
CUCA and CUFIN
CUCA is the paid in fixed and variable capital of a company. The amount is updated with the inflation index every year.
CUFIN is the sum of all retained tax earnings of a company. The amount is updated with the inflation index every year.
The average debt level is calculated by summing up the balances of all interest generating debt at the end of each month and dividing the sum by 12. If the average debt is higher than three times the company´s average equity, it is considered as thinly capitalized by Mexican tax law.
To determine the amount of deductible interest, the ratio of excess debt and average balance of all loans from related nonresident parties is calculated. This factor is then applied to the current interest expenses resulting from intercompany loans. The non-deductible interest expenses will increase your tax base and therefore your income tax payments.
We would like you to be aware that the same factor will be applied to the exchange rate revaluation caused by intercompany loans. Please find below an example of the calculation for better understanding.
Average Equity and Maximum Debt Level
Equity as of 1st of January 2019 1,000,000
( + ) Equity as of 31st of December 2019 3,000,000
( = ) Sum of equity 4,000,000
( / ) Divided by: 2
( = ) Average Equity 2,000,000
( * ) Multiplicated with: 3
( = ) Maximum Debt Level 6,000,000
Calculation of Excess Debt
Average balance of all interest generating debts 9,000,000
( – ) Maximum Debt Level 6,000,000
( = ) Excess Debt 3,000,000
Calculation of Nondeductible and Deductible Interests
Excess Debt 3,000,000
( / ) Divided by
Average balance of all interest generating
Intercompany Debts 9,000,000
( = ) Excess Debt Percentage 33.33%
( * ) Multiplicated with:
Interests from loans with related non resident companies 900,000
Non deductible Intereses 300,000
Debt vs Equity Financing
While a high debt level may lead to non-deductible expenses, equity financing also has some disadvantages we would like to point out. In case that the Mexican entity wishes to pay back a part of the variable capital, there are certain situations where taxes might be applying. The decisive factor is the relation between CUCA and CUFIN in the moment of the capital reduction. (Article 78 LISR)
Capital Increase – How does it work?
To increase a company´s variable capital, a shareholder resolution is obligatory. Subsequently, the resolution must be notarially certified.
Nevertheless, a registration in the Mexican Public Registry of Commerce is not necessary. A capital increase does not require a capital payment as shareholders’ debt (loans or trade liabilities) can be converted into variable equity.