Over 10 years ago I wrote an article on Mexican taxes for expatriate newspapers and websites in Mexico titled, “Mexican taxes: here, there, taxes, everywhere.” To this day I still hear from people who refer to that article. Much has changed in the tax world over the last decade and the time has come for an update.
First, what has not changed: Mexican tax residents are still subject to report and pay Mexican income tax on worldwide income. Paying income tax to your host country is no different than what U.S. residents (or residents from most countries of the world) are expected to do in the country where they live. Though dealing with a new tax system is definitely complex, with proper planning you might find that you actually save on taxes.
Note that tax residence is not the same as legal residence. Tax residence is defined in international tax treaties and local tax laws, while legal residence is based in immigration and nationality laws. Under certain circumstances, you may have the legal ability to live in a country and not be a tax resident of that country. On the other hand, you could be living in the same country with expired or no legal documentation and still be subject to payment of income taxes. Generally, you can only be a tax resident of one country at a time, so it’s important to know who is a tax resident and who isn’t.
In Mexico, tax residence is first understood in light of the tax treaties the country has signed with other nations (the U.S. and Canada, for example). Article 4 of those treaties defines a tax resident as a person who has established an abode in the country. That is, if you have a permanent home in Mexico you are, in the first instance, a Mexican tax resident and subject to pay Mexican income taxes on worldwide income. What happens if you have a home in both countries, as do many of us who travel back and forth? In that case, you are a considered a tax resident of the country where you have your “center of vital interests.” Mexico further defines “center of vital interests” in its Fiscal Code, which says that a person has their center of vital interests in Mexico if either of two things are true:
- Mexico is the country where professional activities are carried out (i.e., work).
- The person receives over 50% of his or her income from sources within Mexico.
If you are not considered a Mexican tax resident, then you are only liable to pay tax on Mexican income sources. Often you will not even have to file a tax return since any withholding at source may be considered final. Tax rates for non-residents are often higher.
Assuming you are a Mexican tax resident, what income taxes are you subject to? Income subject to this tax would include interest, dividends, rental income, capital gains, foreign social security payments, etc. It is important to note that Mexican taxes are not calculated the same way they are in the U.S. or Canada. For example, what is tax qualified in the U.S. or Canada is not tax qualified in Mexico. How cost basis and depreciation are calculated are different too. Exemptions, deductions, tax rates, filing deadlines, and estimated payments are all established by Mexican law and are not the same as our neighbor’s rules to the “Norte.”
It is an unfortunate fact that holding U.S. citizenship (or a green card) also comes with an obligation to file and possibly pay U.S. taxes regardless of where in the world a person might live. As a result, U.S. persons who are also tax residents of Mexico might need to file an income tax return in both the U.S. and Mexico (with each return having its own complexities). Coordinating both sides of the tax equation to obtain the most favorable results can be complicated and some solutions may be counterintuitive. What might be ideal planning in the context of one country could be disastrous in view of a combined plan. Mistakes may lead to penalties costing tens of thousands of dollars, and if non-compliance is willful, even criminal charges may be filed. To make matters even more difficult, it may be hard to find competent tax preparers who have the technical and language skills to do proper international tax planning.
Before you run away, you should know that just because you need to file in two counties does not mean that you pay a double tax burden. Deductions, exemptions, foreign tax credits, and treaty rates all help lower tax burdens significantly. Often, the result is that most of the tax burden is paid to the tax resident country. Done correctly, a move to Mexico might even result in a lower tax burden overall!
Despite what the Mexican tax laws say about registering to pay income taxes on worldwide income, very few foreign nationals do so. Clients tell me that the main reason for non-compliance is that Mexico is not inclined to enforce tax laws on foreign residents (and who wants to pay taxes anyway?). The Mexican tax authority, Servicio de Administración Tributaria (SAT), often does not bring enforcement actions against its own citizens due to a lack of resources. The Authority concentrates its limited resources on businesses and those with some sort of commercial activity (Mexican and foreign), where they expect to get the most bang for their buck. They also know that enforcing tax laws on non-Mexican individuals would send a chill through the large expatriate community and thus have often decided (at least for the time being) to ‘let sleeping dogs lie.’
Many U.S. persons with Mexican sources of income have historically failed to also report that income back to the IRS. Several years ago, I wrote that I believed pressure to comply with Mexican income tax laws would not come from the Mexican authorities, but from the U.S. That prediction has come to pass in the form of a program called the Foreign Account Tax Compliance Act (FATCA). Under FATCA, the U.S. and Mexico now automatically share information on each other’s taxpayers resulting from transactions in their country’s respective financial systems, incentivizing compliance on both sides of the border. Mexico has entered into similar agreements with over 90 other countries under a separate Organization for Economic Cooperation and Development (OECD) program known as the Common Reporting Standards (CRS). Canada has announced that it too will commit to the CRS as of July 2017.
Here’s a brief description of the types of income subject to Mexican income tax laws as they apply to tax residents. Non-tax residents are covered under separate provisions and are not discussed here.
The tax rates reviewed below show the standard tax rates. However, Mexico has signed tax treaties with over 40 countries, including the U.S. and Canada. The provisions in the tax treaties override local law and often will provide lower treaty rates for certain types of income. As a result, any review of tax liabilities for people with foreign sources of income should start with a look at the applicable treaty.
Mexican Tax Rates
Mexican income taxes are applied on a marginal basis and for natural persons reaches as high as 35% (although there is a current proposal with the federal legislature to take the highest marginal rate to 40%). The current Mexican rates could be a good deal if you are coming from a jurisdiction that has higher combined federal and state (or provincial) income taxes. To provide some context, according to OECD statistics, the average effective tax rate for a family with no children in Mexico is 10.8%, which is next to the lowest of 35 countries considered. Per the same study, the U.S. and Canada had rates of 22.7% and 18.9% respectively.
While 35% may sound attractive on the surface, you reach the 35% bracket when income reaches $3 million pesos, which, at current exchange rates, is about $166,000 USD.
Individual states in Mexico are now allowed to charge their own income tax, known in Mexico as impuesto cedular. Most states have chosen not to impose an income tax at present, and those that do, assess only limited types of income. Rates cannot be higher than 5%. Any state tax paid is a deduction on the federal return. The following states impose some sort of income tax: Chihuahua, Guerrero, Guanajuato, Nayarit, and Oaxaca.
Mexican Capital Gains Taxes
Capital gains are not a preference item and are taxed at regular tax rates. There are two major exceptions: gains for the sale of Mexican registered securities and the sale of a principal residence.
Securities registered for sale on the Mexican stock exchanges were once sold at a 0% tax rate. Now gains are subject to a 10% tax. Gains for non-registered securities, such as those realized in exchanges outside of Mexico, pay tax at regular income tax rates. Gains realized within qualified plans abroad are also subject to Mexican income taxes since these plans—401(k)s, IRAs, RRSPs, etc.—are not tax qualified in Mexico. (My firm, Pinnacle Advisory Group, has a portfolio of securities that is tax qualified in both the U.S. and Mexico.)
There are always many questions related to the sale of a principal residence in Mexico and fortunately taxpayers are allowed a homestead exemption on the sale of their residence. What constitutes a principal residence and the exemption amount have changed many times in the last 10 years. Under current law, if you have lived in your home for three or more years and have not obtained another exemption in that period, you can exempt up to about $225,000 USD in gains at current exchange rates. Note that this exemption is supposedly available only to tax residents.
Mexican Rental Income
Rental income is subject to Mexican income taxes. A blind deduction of up to 35% or certain actual deductions are allowed. The taxpayer can take the higher of those two numbers while the remainder is taxed at regular income tax rates.
Rental income is a good example of how both tax systems differ. In the U.S., with rental real estate, taxpayers are allowed to take a very large non-cash deduction for depreciation, often resulting in no taxes due on the U.S. return, and possibly even a deductible loss. However, Mexico does not allow for any depreciation deductions on real estate rentals. On the other hand, the cost of property improvements to rental property can be fully expensed in the year incurred, while in the U.S. these expenses often have to be amortized over their lifetime per IRS tables.
Mexican Interest Income
Interest income is generally subject to regular income tax rates.
Certain types of income, such as those of Mexican government bonds, are exempt. Interest received from foreign sources is also taxable to tax residents. This would include interest paid by U.S. municipalities (generally tax free in the U.S.), as well as interest earned in foreign tax qualified accounts, since these accounts are not considered to be tax qualified in Mexico.
Tax is only due on interest payments to the extent that these exceed the official inflation rate in Mexico. In other words, if inflation in Mexico is 6%, only interest payments above 6% would be taxable. If the interest rate is below the inflation rate, a taxable loss that offsets other income is created (an interesting planning opportunity).
Dividends were historically exempt from income tax if the corporation making the payment had paid income tax on that income to the Mexican tax authorities. In other words, there was no double taxation. But all good things must come to an end—at present, dividend payments are subject to tax rates up to 42%! However, tax on dividend income is a good example of why we look at treaty rates. Dividends paid by U.S. business to tax residents are subject to a 10% rate—significantly lower than the general rule—and 15% if from Canadian sources, per the applicable treaty rates.
Mexican Estate Taxes
Mexico has no estate or inheritance tax applied to tax residents (non-residents that receive gratuitous transfers pay up to 25% of the value of the property received).
Mexican Gift Taxes
Mexico has no gift taxes when transfers are made between ascendants and descendants. In other cases, the beneficiary of the gratuitous transfer is responsible for any income tax generated (non-residents pay up to 25% of the value of the property received).
Mexico has a series of other taxes that apply to both residents and non-residents, including:
- Property Taxes (Predial): very low compared to the U.S. and varies by state and municipality
- Value Added Taxes (Impuesto al Valor Agregado – IVA): 16% in all of Mexico.
- Transfer taxes (Traslado de Dominio): varies by state.
- Automobile Tax (Tenencia): varies by state.
As mentioned above, the Mexican tax authorities often do not have the capacity or will to audit their own citizens in any significant way. I have also found that most Mexican accountants are both unfamiliar with international tax issues and share the mentality that if a tax can be avoided, why bother complying? I would argue that being accepted to live in Mexico brings with it certain rights and obligations to the country, its citizens, and your neighbors… though that has never been a winning argument!
More to the point is the possibility that becoming tax compliant in Mexico could result in significant tax savings overall. But it will require careful planning for a foreigner in Mexico to lower his or her tax burden compared to what they have to pay back home. For example, if you are a U.S. citizen resident in Mexico, life insurance and annuities might be preferred savings vehicles over U.S. qualified plans, interest income might be preferred over dividend income, improvements to property might be more actively encouraged, and so forth.
As a final word of caution, this article very briefly touched upon the Mexican side of the tax equation. Any comprehensive planning will necessarily consider the home country’s tax laws as well, especially if you are a U.S. citizen. As always, every family situation is different and it is absolutely necessary to consult with competent tax experts before making any decisions. No part of this article is meant to provide specific tax advice.
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