Simulation of legal acts by operations between related parties

A latent risk for taxpayers is the classification of their operations with related parties as simulated operations, which may have implications even of a criminal nature. In this study, we review the assumptions in which taxpayers would be in these circumstances and provide recommendations about the case. 

By:

B. Acy, LLB, M.B.A. and M.G.M. Jesús Aldrin Rojas Maldonado, Managing Partner of QCG Transfer Pricing Practice

B.Acy and LL.B. Miguel Ángel García Piña, International Tax Associate of QCG Transfer Pricing Practice

INTRODUCTION

In the Tax Reform corresponding to fiscal year 2022, article 42-B of the Federal Tax Code (CFF) was incorporated, which complements the addition that had been made to section 177 of the current Mexican Income Tax Law (LISR) in force as of 2020, in order to establish assumptions in which the tax authorities can determine the simulation of legal acts when it comes to operations between related parties. 

These modifications should be carefully analyzed by taxpayers to avoid being placed in the legal or regulatory situations provided for by the legislator, as well as by the tax authorities, regarding compliance of specific rules stipulated in this relatively new provision.

ANALYSIS

For purposes of the analysis of this norm, it is appropriate to review what should be understood by the term “legal act”. In this regard, and from a doctrinal point of view, the teacher Rafael Rojina Villegas points out the following:

A juridical act is a manifestation of will that is done with the intention of producing legal consequences, which are recognized by the legal system.

In relation to the legal consequences indicated in the previous definition, section 1792 of the Federal Civil Code (CCF) determines that:

Article 1792. Agreement is the arrangement of two or more persons to create, transfer, modify or extinguish obligations.

Additionally, section 1793 of the Federal Civil Code (CCF) establishes that:

Article 1793. The agreements that produce or transfer the obligations or rights, take the name of contracts.

In that sense, legal acts may be agreements or contracts, among others.

Based on the above, we can point out that the provisions of articles 42-B of the Federal Tax Code (CFF) and 177 of the Mexican Income Tax Law (LISR) indicate the cases in which the tax authorities can determine the simulation of legal acts (contracts or agreements), when it comes to operations between related parties.

When related parties of a corporate group concur in a contract (whether implicit or explicitly), they become eligible for the tax authorities to exercise their verification powers. In other words, the simple fact of agreeing and assuming obligations or rights between related parties, under this new provision, would enable the parties to evaluate the potential existence of a simulated act to the detriment of the tax collection in the country.

As to what is considered simulation, the CCF, in its numeral 2180, states that:

Article 2180: The act is simulated when the parties falsely declare or confess what in reality did not happen or has not been agreed between them.

It should be clarified that there are two types of simulation, in accordance with section 2181 of the CCF: (i) absolute simulation, when the simulated act has nothing real; (ii) relative simulation, when a legal act is given a false appearance that hides its true character.

To exemplify the above, it is useful to consider that in practice these situations can occur in various scenarios. The mere establishment of obligations and acquisition of rights at the contractual level implies that the contracting parties, in order to satisfy such obligations or to safeguard their rights, “activate” their organization by deploying specific activities (functions), employ resources (assets), or even assume risks linked to the operation in which they concur.

Consequently, when the parties acquire obligations and rights linked to a contract between related parties do not display the functions, assets and risks linked with those obligations or do so in a partial manner, a scenario of simulation, either absolute or relative, could be reached.

Under the previous premise, consider, for example, the assumption of a company that undergoes a corporate restructuring, but the taxpayer’s organizational structure does not experience any modification after the restructuring, but it does a significant detriment to their taxable income. Would this be a case of relative simulation, having contractually agreed to the restructuring, but without any subsequent modification of its functions, assets and risks?

In the same sense, what would happen to taxpayers subject to a royalty payment for the apparent use of intangible assets, but that on the part of the licensor there is no prior record of research and development expenditures, and from the licensee no evidence is shown that the royalty has increased its revenues or otherwise benefited from the royalty in any other way? Would this be a case of outright simulation, even if it is taken into account that the licensor registered the intangible, but in reality there is no such underlying asset?

Or, in the best-case scenario, suppose the provision of administrative services, but this is not subject to the obligations acquired and payment of the full consideration is required, eroding the payment of the tax base of the recipient of the services. Would we be facing, either an absolute or relative simulation?

Therefore, in order to avoid falling into any of these situations, it is important that in operating contracts between related parties true facts must be specified, and, in them, clearly state the obligations, rights and distribution of assets, functions, risks and compensation assumed for each of the related contracting parties and that, in addition, the costs, expenses and subsequent deductions that they generate are clearly traceable.

Yet, it should be emphasized that, in order for the tax authorities to be able to determine the simulation of legal acts, it must be in the exercise of their powers of verification and issue a duly founded and reasoned resolution, which must include the following:

1. Identify the simulated act and the act that indeed took place.
2. Quantify the tax benefit obtained by virtue of the simulation.
3. Indicate the elements by which the existence of such simulation was determined, including the intention of the parties to simulate the act. Unfortunately, the antepenultimate paragraph of article 42-B of the CFF indicates that the authority may rely, among others, on presumptive elements, so we should be attentive to the way in which the authority founds and motivates such elements.

On the other hand, it is important to consider that, if the authorities determine that simulation exists, it will, in principle, be exclusively for tax purposes, according to that provision. However, the simulation of a legal act is also a crime that is equated to tax fraud, according to article 109, section IV, of the CFF. So, how could an official refrain from reporting those facts if they could be constitutive of a crime, since he is obliged to do so in accordance with the second paragraph of section 222 of the National Code of Criminal Procedures (CNPP)?

FINAL COMMENT

In summary, as of the Fiscal Year 2022 Tax Reform special attention must be paid to the operations contracts between related parties, having to verify that the contract is the ideal contractual vehicle, which clearly indicates which are the assets, functions, risks and the consideration that each of the parties will execute, to the effect that, when the tax authorities review them within the framework of the exercise of its verification powers, they will  have no doubt that such operations exist and that they are real operations and not simulated as indicated  in article 42-B of the CFF, in relation to section 177 of the LISR. Failure to do so can place taxpayers under the transfer pricing regime in an extreme risk situation or even condition their operation.