US Expats in Mexico – 5 Key Tax Principles

April 07, 2021

By Joshua Ashman, CPA & Nathan Mintz, Esq.

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Largely due to its contiguity with the United States, Mexico continues to be the most popular destination in the world for US expats. According to a US State Department estimate, approximately 1.5 million Americans currently live in Mexico.

US expats living in Mexico are uniquely situated from a tax perspective because they are subject to both the US and Mexican tax systems. Coordination of the two systems is essential to avoid the double taxation of your income.

In this blog, we include a brief comparison of the US and Mexican tax systems for individual taxpayers. We then provide 5 key principles that serve as a good starting point for understanding how to navigate the main tax issues facing US expats in Mexico.

Introduction – Comparing the US and Mexican Tax Systems

The Mexican tax system has a number of similarities to the US federal income tax system as well as significant differences. Mexico taxes its residents on their worldwide income, like the United States.

However, unlike the US, Mexico does not have citizenship-based taxation. This means that unlike the US, Mexican citizens living outside of the country are generally not subject to Mexican taxation.

Like the US, Mexico has a progressive tax system, where tax rates for an individual increase as income rises. In Mexico, the highest personal income tax rate is 30%.

Also like the US, the default Mexican tax year for individuals is the calendar year. Tax on employment income is withheld by the employer and remitted to the tax authorities, while certain other types of income, such as services income, is subject to tax withholding.

To report and pay tax on other income, Mexicans must file a tax return and, when required, make prepayments of tax. The filing tax deadline is April 30, with no extensions.

Principle #1 – Your Obligation Endures as a US Expat in Mexico

For US citizens living in Mexico, our first principle is of particular importance. US expats often mistakenly believe that once they have moved abroad their US tax obligations cease to exist.

In fact, as a basic expat tax rule, US citizens, even those residing outside the United States, are subject to US tax reporting on their worldwide income. Expats must annually report all of their income to the IRS, just as they did prior to moving to abroad, whether the income is US source or foreign source, and whether that foreign source is Mexico or any other foreign country.

Principle #2 – Your New Filing Obligations as a US Expat in Mexico

US expats who hold accounts or other assets overseas are subject to a number of additional filing obligations. The failure to file any of these forms can result in severe civil penalties, such as a $10,000 penalty per form per year. Criminal penalties can apply if it’s determined that your non-compliance was willful or your actions were otherwise fraudulent.

Some of the more common forms include:

  • Foreign Bank and Financial Account Report (FBAR)
  • Form 8938 (FATCA)
  • Entity-specific forms, such as the Form 5471 (foreign corporations), Form 3520 (foreign trusts), and Form 8865 (foreign partnerships)

Principle #3 – Additional Reporting for Activities in Mexico

With each item of income that a US expat in Mexico earns and with each foreign asset that is acquired, special rules may apply.

Pension Ownership:

While Mexican pensions may benefit from special treatment under Mexican tax law, they may have very different treatment under US tax law.

For example, if you have a Mexican pension account (an AFORE account) or a retirement account (a Fondos para el Retiro account), special US tax rules may apply. Although an AFORE has preferential tax treatment under Mexican tax law, it may have severely adverse tax and additional reporting consequences if treated as a passive foreign investment company (PFIC) under US tax law.

The IRS FBAR Reference Guide also specifically states that both types of accounts are foreign financial accounts reportable on the FBAR.

Company Ownership:

For US business owners in Mexico, different rules would apply depending on the Mexican business entity that you choose as your operating vehicle.

Typical Mexican entities include the Sociedad Anónima de Capital Variable (S.A. de C.V.), which is similar to a corporation in the US, and the Sociedad de Responsabilidad Limitada de Capital Variable (S. de R.L. de C.V.), which is similar to an LLC in the US.

Under the US entity classification rules, the S.A. de C.V. is required to have the status of a corporation for US tax purposes, while the S. de R.L. de C.V. can choose a classification other than corporation (e.g., partnership or disregarded status).

A non-US corporation owned by a US person may be considered a controlled foreign corporation (“CFCs”) for US federal income tax purposes, a classification that can potentially have significant US tax implications. For instance, a 10% or more US shareholder of a CFC must include currently in his or her gross income the CFC’s so-called “subpart F income,” which generally includes passive-type income, such as interest, dividends and rental income (meaning, for tax purposes, a CFC’s subpart F income is considered to be earned directly by the shareholder prior to an actual distribution to the shareholder). Non-subpart F income, which generally includes active type-income, such as business sales or services income, will also be required to be included currently at the shareholder level under the new so-called “GILTI” rules.

Careful attention must be given to the US tax implications of foreign company ownership in order to insure your business in Mexico operates tax efficiently.

Principle #4 – Tax Benefits for US Expats in Mexico

The good news for expats living in Mexico is that both US domestic tax law and US-Mexico bilateral agreements contain a number of provisions that are designed to prevent “double taxation,” or taxation on the same income in both countries.

These provisions, in many cases, can reduce or even eliminate the US federal income tax that would otherwise be due by the expat taxpayer. Keep in mind, however, that even if no US tax is owed, a US tax return still generally must be filed and the failure to do so can result in severe penalties.

Important domestic law provisions include:

Important tax agreements include:

  • US-Mexico Income Tax Treaty – This treaty is designed to mitigate the effects of double income taxation. Generally, under the treaty, expats may be entitled to certain credits, deductions, exemptions and reductions in the rate of income taxes of the foreign country in which they reside.

Principle #5 – FATCA Extends the US Government’s Reach

The “Foreign Account Tax Compliance Act” (FATCA) is designed combat offshore tax evasion by requiring US citizens to report their holdings in foreign financial accounts and their foreign assets on an annual basis to the IRS. As part of the implementation of FATCA, the IRS requires certain US citizens to report (on Form 8938) the total value of their “foreign financial assets.”

In order to further enforce FATCA reporting, foreign financial institutions (“FFIs”) (which include just about every foreign bank, investment house and even some foreign insurance companies) are required to report the balances in the accounts held by customers who are US citizens. To date, we have seen several large foreign banks require that all US citizens who maintain accounts with them provide a Form W-9 (declaring their status as US citizens) and sign a waiver of confidentiality agreement whereby they allow the bank to provide information about their account to the IRS. In some cases, foreign banks have closed the accounts of US expats who refuse to cooperate with these requests.

The US currently has a FACTA Model 1 intergovernmental agreement (IGA) with Mexico. Further, the Associated Press recently reported that Mexico’s business dealings with other Model 1 IGA jurisdictions essentially allow the US to circumvent its direct agreement in order to procure information for the IRS.

If you are a US expat living in Mexico, it is essential that you remain compliant with your continuing US tax obligations. Our experts at Expat Tax Professionals are available to help you understand your US tax filing requirements and to assist you with all of your US tax compliance needs.

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