Comparing Tax Rates and Tax Policies for US Earned Income and Mexican Earned Income

March 17, 2013
For CURRENT details, see our master article on taxes at: IRS Tax Issues for Americans Living and Working Abroad in Mexico – Master Article

When a US citizen one considers moving to Mexico,   is there a rational approach to figuring out how to minimize our tax burdens?     Can we possibly structure (adjust or control) where we work and where we are paid to legally minimize the taxes we pay to the two countries?

Many people are locked into what taxes they pay,   and where they pay them,   but US expats moving to Mexico have some options not available to everyone else.   Further complicating things:   There are whole rafts of rumors that swirl and circulate around in gringo enclaves and on gringo forums about tax laws.    Still, it maybe worth gleaning and compiling a some facts, quotes, expert insights & opinions, and official decisions we’ve encountered over the past 15 years of doing US and Mexican Resident & Non-Resident returns.

Disclaimer:   This article is mainly directed at how US and Mexican tax laws interact/mesh, including details and references to Mexican tax law (see the ISR),   and the US IRS tax codes.    We make this disclaimer because there is also a   IRS: UNITED STATES – MEXICO INCOME TAX CONVENTION – 1993    that governs just how the countries integrate their overlapping tax policies and (hopefully) resolve contradictions.    As such,  the tax information given in this article is tempered by the oversight of that 1993 US-Mexico Tax Treaty – which at times overrules the tax laws of each country – so, please understand that if you find something that does not fit with your particular understanding of your country’s tax code,   it may be due to the US-Mexico Tax Treaty and subsequent rulings by each government.

Back to the main article:

First, consider how apparently simple rules or principles may not actually work in practice as they appear on paper.    For example, Hacienda (the Mexican Treasury Dept.) has a general policy that Mexican resident’s worldwide income must be reported by expats whose principal place of activity is Mexico.   Pause.    Just what does that “principal place of activity” really mean?

Then, consider how does our “principle place of activity” affects Americans moving to Mexico.   (For reference:  “Principle place of activity” is US terminology – aka “center of vital interests”   in the Mexican ISR tax code. )   One practical but unexpected result:  While doing past research on tax obligations,  Hacienda and INM supervisors have personally explained:   If an American residing full time in Mexico works online , works for a Canadian internet company (doing no work for a Mexican employer),   and they receive their pay outside of Mexico,    then   no   taxes are owed to Mexico.   In this case, taxes are owed in the USA where the income is paid,   even though the expat is a full time Mexican resident working for a Canadian company.   ~ Why ask INM?  It is important for expats to get the correct/proper type of residency permit, that fits their working status. ~

How does an American living & working full-time on the internet in Mexico, paying no income taxes in Mexico, jibe with the pesky principle:  Hacienda’s policy that Mexican resident’s worldwide income must be reported by expat residents living in Mexico?   If the gringo works in Mexico and legally resides in Mexico,   how can they owe   only  US taxes?

It all comes down to the precise legal definitions of   “principal place of activity”  terminology – aka “center of vital interests” .

Universal Disclaimer:   For complex situations, talk with a good tax professional who knows international tax law and the US-Mexico Tax Treaty.   We offer these stories for only informational and entertainment purposes, not as tax advice nor legal advice.  Still, it can be useful to read what other experts have published.

When considering the issue of   “principal place of activity”  (aka “center of vital interests”) as related to our “tax home” (IRS terminology)  or “tax residence”  (ISR terminology),  versus our personal residence,  it really does make better sense to quote an expert:

Mexican Taxes by Raoul Rodriguez-Walters, CFP® Mananging Partner, Mexico Advisor,  identifies the importance of distinguishing between  our “legal residence” and “tax residence”  (from the section “Mexican taxes”, linked to from the left-hand column):

“Legal residence and tax residence are two different concepts.   The first is related to the authorization, generally from the immigration authorities, to be in Mexico for a given period of time.     This authorization comes is various forms, typical examples of which are evidenced in a tourist card or an FM-3.    Tax residence, on the other hand, is defined in the tax law and tax treaties.    The distinction between who is a Mexican tax resident and who is not is important because generally non-residents are subject to higher taxes than tax residents.”

“In 2004,   the Mexican Fiscal Code (the “Code”) established a new definition of “tax resident,”  as anyone who has established an abode in Mexico,   irrespective of the time he or she has spent in the country.   The Code also stipulates that if you have one home in Mexico and another abroad,   you are considered a tax resident of the country where you have your “center of vital interests.”   Mexico considers that your center of vital interests is in Mexico if   over 50% of your income is derived from Mexican sources,   or   if you are employed (or self-employed) in Mexico.”

“There are two main repercussions for a foreigner in Mexico as regards tax residency.   The first is that tax residents are supposed to register to obtain a tax ID,   known as an “RFC”, and file an annual tax return reporting worldwide income.    The second, and perhaps more of an immediate concern to many foreigners who own real estate in Mexico,   is the ability of the foreign national to obtain a tax exemption on the sale of their Mexican residence.    This income tax exemption is outlined in the section of the Mexican Income Tax Law applicable to tax residents and is clearly meant to benefit taxpayers who have been complying with their Mexican income tax obligations.” (Author’s note:  The homeowners exemption and capital gains taxes on Mexican property sales changed dramatically in Feb. 2010.  See:   Capital Gains Taxes on Mexican Properties )

“The good news is that with proper financial planning you can permanently and legally live in Mexico without acquiring a Mexican tax ID, filing a tax return or paying income taxes on foreign income (Mexican source income is still subject to tax).    By doing so you may give up the benefit of lower Mexican taxes available to tax residents but you will gain a greater level of peace of mind.”

Hmmm….. “…  lower Mexican taxes available to tax residents …”  Intriguing claim.

Does it hold up to scrutiny?

Let’s use a real world example of an expat consultant who can jigger their work and their payments to be in either Mexico or the USA.    Let’s assume the consultant makes $95,100 USD a year,  (coincidentally the maximum IRS allowed Foreign Earned Income per year for 2012).     Next:  If the consultant sets up their “center of vital interests”/”principle place of activity” to be Mexico,  then there is no tax owed in the USA.   Let’s call that Scenario #1:

In Scenario #1 : When we arbitrarily force the $95.1K of income to be earned in Mexico and paid in Mexico, then it is hit with an escalating scale of taxes, based on how much is earned.  i.e. The lowest rate:  1.92% taxes are owed on the first $5,953 MXN pesos ($114 pesos in taxes).   At the highest rate: 30% Mexican income taxes are assessed on every dollar over $26,373 USD in income.  Take a look at how that breaks down….

For our consultant’s $95,100 USD of 2012 Mexican income:
1.92%   on     $0 – $5,953 MXN= > $114 MXN in taxes
6.4%   on     $5,954 – $50,525 = > $2,853 MXN in taxes
10.88%   on     $50,256 – $88,793 => $4,163 MXN in taxes
16%   on     $88,794 – $103,218 = > $2,307 MXN in taxes
17.92%   on     $103,219 – $123,580 = > $3,649 MXN in taxes
21.36%   on     $123,581 – $249,243 => $26,841 MXN in taxes
23.52%   on     $249,244 – $342,842 => $22,014 MXN in taxes
30%    on    $342,843 – $1,236,300 MXN ($95.1K income)** = $268,037 MXN in taxes
This sums to $329,978 MXN in total Mexican taxes on the $95.1K deduction

=> $25,382 total USD in taxes owed to Mexico .

(at $13MXN:$1USD)

Now,  let’s consider a Scenario #2 , where the $95.1 K is earned and paid in the USA, then the American consultant living full time in Mexico would pay the US IRS:
10% on the first $17,850 = $1,785 in taxes
15% on the $17,850 – $72,500 => $8,197 in taxes
25% on the $72,500 – $82,900*** => $2,600 in taxes

This makes a total of just $12,582 of US Federal income taxes owed at 2013 rates on the same $95,100 USD of income (for married taxpayers filing jointly  which includes the 2013 standard deduction for married filing jointly because the consultant is married).

**Mexico Tax and Tax Laws – 2013: World-Wide Tax.com

***2013 Tax Rates: Forbes

Conclusions?   Mexican tax law is clearly more complex than US tax law.    Also, as many analysts have pointed out, USA has some of the very lowest tax rates in the world.   This also shows that the spouse’s consulting income can be earned outside of Mexico and deposited in the USA, it saves $12,801 by paying the low US rates.

Note that a US taxpayer would have to earn over $223,050 USD a year to finally reach US tax rates that exceed the top Mexican tax rate.   Do any off us expect to exceed $223,050 a year in US income and IRA withdrawals?

Which country actually has the lower rates at income levels $$$ that many common Americans earn?

Let’s pick a common tax rate to compare the graduated scales for Mexico and the USA:

Mexico has a net 15% tax rate on the the first $209,300MXN ($16,100USD) of income.

The USA has a net 15% rate on the the first $81,400 USD.

Did anyone else notice the inconsistency?   The tax expert quoted above says that Mexico has the lower tax rates  (which is true for less than $16,100 USD of income), but the US has much lower rates for everything above that….  How many of us make more than $16,100 USD a year?

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Conclusions:

Mexican taxes are lower if you make less than $16,100 USD a year … or more than $223,000 a year,  and the US has the lower rates for  everything between $16,100 – $223,000…

If so, then Mexico would have net lower tax rates. Otherwise, paying US taxes looks way more attractive.

Still, on the other hand, Mexican individuals who play the stock market pay… 0% in taxes on their gains….

This means you probably should cash out all your US investments and move to the Bolsa… especially when you compare Bolsa performance over the past 5 years to the US market performance… (370% Bolsa return vs 2% for US markets)**
… No taxes and better returns is clearly a no-brainer if you are all about the $$$… Plus, Mexico has the best projected economic growth for the Western Hemisphere for the next 5 years.

Anyway, the USA clearly has the best salaries and the lowest tax rates for your wife’s income situation, if you can jigger her income to be paid in the USA, and if you can keep her “center of interest” and tax residence legally in the USA. … a tough sell as a US citizen living and working full time in Mexico…?

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Useful Notes:

An alternative minimum tax, AMT, of 17.5% applies for income on cash flow basis.
Non-residents pay 15%/30% on their employment income in Mexico. The first $125,900 MXN are tax exempt subject to terms.

Corporate Tax:
Mexico’s corporate tax rate for 2012 is 30%. The corporate rate will be reduced to 29% in 2013 and 28% in 2014. An alternative minimum tax ,AMT, of 17.5% applies to income on cash flow basis.

Capital Gains:
Capital gains of companies are added to the regular income.
Individuals: Gains from sale of securities in the Mexican stock exchange are tax exempt.
Sale of the principal residence is also tax exempt subject to certain terms.

Residence
A foreign company is resident if managed in Mexico.
An individual is resident when holding a home in Mexico or when the center of life is in Mexico
Resident companies and individuals pay taxes on their worldwide income too.

Mexico Tax Deductions
Losses are carried forward up to ten years. There is no carry back of losses.

Depreciation is deducted using the straight line method. The depreciation rates are as follows:
Machinery- 10%
Furnitue-10%
Buildings- 5%
Cars and Trucks- 25%
Computers- 30%.

There is optional company consolidation for tax purpose in Mexico.
Thin capitalization rules relating to interest expenses are in effect in Mexico with 3:1 debt to equity ratio for loans from related parties.
Donations are tax deductible for up to 7% of previous year taxable income.

Mexico Personal Credits and Deductions
There is a tax credit for each dependant.
Education expenses are deductible, up to a limit.
Deductions are also permitted for social security payments by an employee, and payments to private pension plans, up to a limit.
Funeral expenses are tax deductible up to a limit.
Medical expenses are deductible subject to a ceiling.
Donations to organizations, subject to terms, are tax deductible.

Deduction of Tax at Source
In Mexico tax is deducted at source from the following payments to non residents:
Dividend- 0%.
Interest- 30%.
Royalties- 30%
Technical Services -25%.
Branch Remittance Tax -0%.

Social Security
The contributions by the employer and the employee are subject to ceiling defined by law covering retirement fund, housing fund, death and inability.    The payments are divided roughly to two thirds by the employer and one third by the employee.    Payments to social securities are due on a monthly basis.

http://www.worldwide-tax.com/mexico/mexico_taxes.asp

Universal Disclaimer:   For complex situations, talk with a good tax professional who knows international tax law and the US-Mexico Tax Treaty.   We offer these stories for only informational and entertainment purposes, not as tax advice nor legal advice.

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If you liked this article, you might also check out our growing body of articles on tax issues for expats in Mexico:
~ Capital Gains Taxes on Mexican Properties
~ Income Tax Liabilities in Mexico
~ Fideicomisos and FATCA: US – Mexico Agreement on FATCA Reporting Requirements
~ IRS Reporting Requirements for Mexico: Fideicomisos / Mexican Land trusts
~ FBAR’s and Fideicomisos: To File or Not to File, That is the Question ,
~ US Income Tax Filing Information for Ex-Pats
~ Tax Issues for Americans and Other Expats Living in Mexico
~ Updated 2011 IRS Requirements: Foreign Account Tax Compliance Act (FATCA)
~ Summaries of US Tax Laws Affecting Citzens Living Abroad ~ 2013
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Feel free to copy while giving proper attribution: YucaLandia/Surviving Yucatan.
© Steven M. Fry

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