By Baker & McKenzie

The 2005 tax reform entered into effect on January 1 of said year. The Income Tax law was amended to introduce the so-called "Cost of Sales" deduction system. The rules of the new cost of sales are very complex. Following you will find the answers to the most common questions in this respect.

1. What are the cost of sales rules?
The cost of sales rules came into effect as of January, 2005. These rules allow taxpayers to deduct, for income tax purposes, acquisitions of merchandise, raw materials, semifinished and finished products, only in the year when the income resulting from the corresponding sale of goods in question is accumulated for income tax purposes.

2. To whom do the new rules apply?
The new cost of sales rules apply to legal entities who sell goods and/or provide services whereby goods are provided (for example, construction services). The cost of sales rules do not apply to individuals or entities that provide "pure services" (services through which goods are not provided).

3. Do they affect taxpayers?
It depends on the type of activity that the taxpayer performs. The new cost of sales rules affect, for example, taxpayers who for any reason purchase goods in a given fiscal year and that based on the rules cannot deduct such expense until a future tax year. The deduction allowed by the cost of sales rules is determined on a historical or predetermined cost basis, as opposed to an indexated (revalued for inflation) cost basis.

4. Can their impact be avoided? How?
Yes. Taxpayers can file a court action called "Amparo Action" against laws that do not conform to the Federal Constitution. The law establishes a legal term of 15 working days to file amparo actions against legal provisions, as of the date of their "first act of application" (which could be, for example, the payment of a tax under certain legal provision, an authority´s denial to refund a tax based on certain legal provision, etc.). Where an action is not brought within such term, then the legal provision in question is deemed "consented", which bars the person in question from seeking relief at any future point in time. Although subject to a case-by-case analysis, the "first act of application" of the legal provisions that establish the cost of sales system is the filing of the monthly tax return for January, 2005.

As mentioned above, taxpayers may file an Amparo Action against laws that do not conform to the Federal Constitution. The cost of sales rules have many constitutional flaws, violating the Federal Constitution.

5. What are the legal effects of filing and obtaining a favorable decision with an Amparo Action?
Determining exactly what the result of securing a favorable amparo decision would be is unpredictable. From a strict legal standpoint, the effect should to obtain relief from paying income tax (not paying any income tax at all). However, a more realistic effect, considering the actual trend of the Mexican courts, would be returning to the so-called "purchases deduction system", in effect until 2004.