By Baker & McKenzie

Deduction of Employess´Profit Sharing
Employers are mandated by law to distribute 10% of their profits to their employees. The Income Tax Law (ITL) for 2002 did not allow the deduction of employee profit sharing ("EPS") paid to employees. It provided that deduction would be allowed during 2003 if certain official estimates showed a 3% gross domestic product growth projection. According to the transitory articles of the tax reform for 2003, the EPS would be 40% deductible during fiscal year 2004 and 80% deductible in 2005, with certain adjustments. Such adjustments consist in subtracting from the EPS the tax deductions related to the rendering of personal subordinate services, which are exempt income for employees.

It is important to mention that several companies filed an amparo action (constitutional action) against the limitation to deduct EPS granted to employees in the year of 2002. Nonetheless, the Supreme Court of Justice of the Nation ("SCJN") resolved, by majority of votes, on May 4, 2004, that the fact that the ITL provisions referred to in the above paragraph that prohibited the deduction of the EPS granted to employees during the year of 2002 was not against the constitutional taxation principles. Nonetheless, the SCJN resolved, on November 30, 2004, by majority of votes, that the ITL provisions that prohibit the deduction of EPS granted to employees are against the tax principles established in the constitution, and therefore, such provisions are unconstitutional.

The resolution mentioned in the preceding paragraph is a non-binding precedent and, as a consequence, under law, its application is not mandatory for federal courts. However, we may assume that, in practice, most of such courts will apply the above-mentioned criterion. Such criterion may also be applied in amparo actions filed against the provisions in force for tax years 2004 and 2005.

In our view, such provisions violate our constitutional taxation principles, by not allowing taxpayers to deduct a legitimate expense. Taxpayers that want to deduct 100% of the EPS have to file an amparo action claiming the unconstitutionality of the provision that prohibits . The amparo action must be filed within the 15 working business days following the filing of their 2004 annual tax return.

Calculation of Employees´Profit Sharing
On a related matter, our Constitution provides that the basis on which the EPS has to be calculated is the taxable income.

The ITL defines what should be understood as taxable income for EPS purposes, distinguishing it from the taxable income for income tax purposes. As an example, in so defining, the ITL excludes from the calculation of "taxable income" for profit sharing purposes, the prior year's net operating losses ("NOLs"). The obvious result is that employers with NOLs will not be able to subtract them and will thus end up with "taxable income" for profit sharing purposes, albeit with no taxable income for income tax purposes. In other words, they will be paying EPS despite not having taxable income for income tax purposes.

The Constitution is the supreme law of the land, and all laws must conform to it. Thus, the definition in the ITL of a "taxable income" for EPS purposes violates the Constitution by establishing a formula for its calculation different than the one established in the Constitution. The Constitution simply refers to taxable income as the basis to calculate the EPS, and taxpayers have only one taxable income, both for income tax and profit sharing purposes. This criterion has been confirmed by the Supreme Court in prior cases.

Article 16 of the ITL, which establishes the procedure to calculate the base for the EPS, was amended as of January 1, 2005. Thus, employers may file an amparo action to be allowed to consider as "taxable income" for profit sharing purposes the same "taxable income" used for income tax purposes for 2005 and future years. There is also a legal procedure in order to be able to calculate EPS for year 2004 considering the same "taxable income" used for income tax purposes.