Mexico: Understanding SAT's "benchmark" disclosure of effective income tax rates
Mexico’s tax authority, the SAT (for its acronym in Spanish), has issued expected effective income tax rates for large taxpayers related to 40 economic activities. The SAT’s goal in this is to encourage taxpayers to effectively comply with their tax obligations, to verify their effective rate, and, where appropriate, to take steps to adjust their tax position (by filing amended returns) to avoid tax audits.
The SAT has frequently expressed its intention to increase tax collections from large taxpayers by improving the audit process, thus providing a framework of legality and certainty for taxpayers. Seeking to make this objective a reality, it has carried out several actions, among which we highlight:
- In February 2021, the 2021 Master Plan of Operation was published by the SAT’s Large Taxpayer’s division, indicating the economic sectors that were subject to audits in 2020, the scope of these audits, and the taxes that were reviewed, as well as the main economic sectors that will be reviewed in 2021 and the extent of SAT’s cooperation and information exchanges with other countries to strengthen Mexican tax audits.
Finally, in that document, the SAT mentioned that the recent reforms to Mexican tax law have been made to optimize the tax system recently reformed measures have included: i) providing benchmarks for profit margins, deductions and rates by sector; (ii) business reason requirements; (iii) reportable transactions; (iv) interest expense limitation provisions.
- In December 2020, an amendment to the Federal Tax Code was published, specifically article 33, first paragraph, section I, subsection i). This modification allowed tax authorities to provide taxpayers with parameters (benchmarks) regarding profit, deductible concepts, effective tax rates and profit margins based on economic sector or industry.
The purpose of disseminating this information is to measure tax risks, so that taxpayers, their legal representatives or, in the case of legal entities, their management/governing bodies can detect and address risk assumptions and can then opt for voluntary compliance with these parameters.
- On June 13, 2021, the SAT released the first benchmarks regarding effective tax rates for 40 economic activities for fiscal years 2016 to 2019. This information is relevant for large taxpayers because the statute of limitations has not yet expired for those years.
The aforementioned benchmark is the result of analyses carried out within the SAT of the institutional databases that contain such information as annual returns, tax reports (Dictamenes fiscales), information on the tax situation of taxpayers, informative returns, digital tax receipts, and entry summaries (pedimentos).
The SAT’s purpose in issuing the benchmarks is to inform large taxpayers of the rate corresponding to their economic activity (as determined by the SAT) so that they may compare it with their own effective tax rate for each fiscal year to measure tax risks and, if applicable, adjust their fiscal positions through an amended annual income tax return. The latter action would allow them to minimize the risk of a deeper review from the SAT. The benchmark rates may be seen on the SAT’s website.
The SAT has announced that it is currently working on benchmark effective tax rates for the remaining economic activities of Annex 6 of the Tax Miscellaneous Rules (in addition to the 40 economic activities already released) and will shortly publish the results.
What is the benchmark?
The 40 economic activities initially considered by the SAT are part of five economic sectors: mining; manufacturing industries; wholesale distributors; retailers; and financial services and insurance. The manufacturing and retailers’ economic sectors are heavily focused on automotive and pharmaceutical products.
The effective tax rate is defined by the SAT as the ratio of income tax to revenue. According to the SAT, the “effective tax rate” for each economic activity was determined based on a consolidation of taxpayers by relevant economic activity, taking into account the relevant economic activity reported before the SAT in the registration on the Federal Taxpayers Registry as well as the most updated annual income tax return of each of the relevant fiscal years. Additionally, the SAT indicated that taxpayers with an effective tax rate greater than the referenced rate have a low risk of audit, while taxpayers with a lower-than-referenced effective tax rate have a higher risk of audit.
In order to minimize the tax risk of a deeper review in each of the fiscal years 2016 to 2019, the SAT’s expectation is that the effective tax rate reported by taxpayers is equal or above the percentages determined by the SAT for each fiscal year (expected effective tax rate). The ratio reflects the taxes that a company should have paid in taxes from its revenue. As an example, a taxpayer who manufactures or assembles automobiles and trucks should have paid, on MX$100 of revenue, MX$1.32 in taxes – meaning 1.32 percent is “the effective tax rate.” Also, in the same automotive segment, companies that manufacture parts for automotive vehicles should pay taxes of 5.32 percent on each MX$100 of revenue.
It is important to highlight that the “effective tax rate” could be used to calculate an implicit operating income before taxes to sales ratio (applying certain general assumptions). This ratio can be a more realistic measurement of profitability in measuring and performing a benchmark analysis. As an example, we took the same ratio – an effective tax rate of 1.32 for the assembly of automobiles and trucks. This rate could translate into an implicit operating margin (before taxes) of 4.40 percent (based on certain assumptions). In the other example, the 5.32 percent effective tax rate for the sector of manufacture of other parts for automotive vehicles could translate into a 16.43 percent operating margin (before taxes) (including certain assumptions). This expected profitability seems a significantly high bar of expected profitability for a company operating in that sector during fiscal year 2019 based on benchmarks of public companies (North America Region) with public available information included in a similar industry and sector (NAICS code).
Relevance of the benchmark to transfer pricing
Benchmark analyses are usually applied in the economic analysis performed in transfer pricing documentation to establish compliance with the arm’s length principle.
One of the transfer pricing methods commonly applied by Mexican taxpayers is the transactional net margin method (TNMM). This methodology requires establishing a benchmark analysis of companies that perform similar functions, assume similar risk and hold similar assets under a similar “industry” to the tested entity, which in most cases is the Mexican taxpayer.
This benchmark published by the SAT reveals an expected operating margin behind the “effective tax ratio” (under certain assumptions) that companies should be obtaining. If the Mexican taxpayer has a significant portion of its revenues or deductions with related parties, it seems that the natural process for assessing a higher tax rate will be through an adjustment in its transfer pricing. Therefore, taxpayer should carefully review their transfer pricing policies, their documentation, the comparable companies used in the benchmark analysis and any deviation from the results of the expectations of the tax authority, to arrive at a correct risk assessment that will serve the company and allow it to take appropriate actions for compliance with the arm’s length principle.
In the analysis performed in the sector of the manufacturing of auto parts, the median of the eight different sectors in a three-year average stated a 8.2 percent operating margin. This 8.2 percent operating margin usually might be in the upper side or above the range of potential comparable companies usually applied of companies operating in that industry (under certain facts and circumstances). This can anticipate that a detail review of the comparable companies and the range during a transfer pricing audit.
This benchmark analysis published by the SAT has to be carefully analyzed by the Mexican taxpayer and their headquarter for carefully reviewing their transfer pricing policy, results and documentation so they are ready to support the arm’s length results and the potential difference in the expectations of profitability that the local entity should be obtaining through the correct application of the arm’s length principle.
Even though the effective tax rates determined by the SAT for 40 economic activities are not binding for taxpayers, it is expected that the SAT will use these effective tax rates as a reference to identify taxpayers for tax audits.
For Mexican entities – whether or not their economic activity is included in SAT’s initial analysis – it is prudent to be aware of these new developments and the coming publication of the expected effective tax rates, while increasing their efforts to gather robust documentation that will support their tax position.
 SAT Internal regulation, article 28, section B, defines as large taxpayers, among others, the following entities: (a) financial institutions; (b) integration group regime companies (former consolidation regime); (c) taxpayers in the general corporate income tax regime that declared in the last income tax return at least gross income of 1,250 million pesos, updated to January 2021 to 1,567,864,162 million pesos; (d) foreign residents; (e) any individual or legal entity engaging in transactions with related parties or investments under preferential tax regimes.
 The economic activities derive from Annex 6 of the Tax Miscellaneous Rules in which the SAT has published what are the economic sectors and industrial activities in Mexico.
 In this sense, in Mexico the definition of an economic activity derives from the concept “line of business” that is defined by Article 2, Section VIII of the Commercial Chambers and their Confederations Law (CCCL) as the economy sector or area that by its characteristics it is integrated into a single group of productive activity. Said provision that is in accordance to the current official classification of production activities recommended by the INEGI (National Statistics Institute). For this purpose, the current official classification of productive activities recommended by INEGI is embodied in the North American Industrial Classification System (NAICS). The hierarchical structure of the NAICS is made up of five levels of aggregation: sector, sub-sector, branch, sub-class and type of activity. In these terms, according to the definition established by article 2, section VIII of the CCCL and the NAICS, it is observed that the term refers to the sector level of aggregation established by the NAICS. In this regard, the NAICS is composed of 20 activity sectors. Tax authorities used that knowledge for the preparation of the Catalog of Economic Activities, included in Annex 6 of the Miscellaneous Tax Resolution, the NAICS was adopted as the basis of said catalog. Accordingly, the term of line of business, corresponds to each of the 20 sectors that are referred to in the Catalog of Economic Activities established by Annex 6 of the Tax Miscellaneous Rules. In the benchmark published by SAT it can be observed that the 40 economic activities are a mix of sector, sub-sector, branch and sub-class on the types of activities, not per se economic activities. Upcoming benchmark for different economic activities is expected to come from the Annex 6 but very likely to continue mixing sector and subsectors.]
 As a reference used for purposes of this example.
 Includes Mexico, Canada and the US.
 We included an adjustment that reflect a reduction of the tax rate of 30% to 20% due to additional deductions that the taxpayer can obtain due to items below the operating income line (expenses on interest and other non-operative expenses) and other assumptions were applied.