The annual inflation adjustment is one of the most confusing tax calculations due to its complexity. Its purpose is to reflect the impact of inflation on a company's debts and credits and how this inflation can generate taxable income or authorized deductions.

What is the Annual Inflation Adjustment?

To better understand it, we will define “inflation” as: “The generalized increase in prices within an economy, which reduces the purchasing power of money.”

According to the Income Tax Law (ISR), the inflation adjustment depends on the relationship between the company's credits and debts. If a company's credits exceed its debts, inflation decreases their real value, representing a loss of purchasing power for the company. In this case, the inflation adjustment is deductible as it reflects a financial loss. Conversely, if the debts are greater than the credits, the company benefits because inflation reduces the real value of what is owed, generating an economic gain. In this case, the inflation adjustment is taxable, increasing the company's taxable income.

How is the Inflation Adjustment Calculated?

The inflation adjustment is calculated at the end of each fiscal year, using the following steps:

1. Determine the annual average balance of debts and credits:
   • The balances of debts and credits at the end of each month are added together and divided by the number of months in the year. This gives the annual average balances.
2. Compare the average balances of debts and credits:
   • If the debts exceed the credits, the inflation adjustment will be taxable, meaning it increases the company's taxable income.
   • If the credits exceed the debts, the adjustment will be deductible, reducing the taxable income.
3. Apply the annual adjustment factor:
   • The annual adjustment factor is obtained by subtracting 1 from the quotient between the National Consumer Price Index (INPC) for the last month of the fiscal year and the INPC for the last month of the previous year.

Example of an Inflation Adjustment Calculation

Imagine a company has an average annual debt balance of $1,000,000 and an average annual credit balance of $800,000. The difference between the two is $200,000, and let's assume the annual adjustment factor is 5% (0.05).

The calculation would be as follows:

• Taxable inflation adjustment = $200,000 * 0.05 = $10,000

This adjustment of $10,000 would be taxable, meaning the company would have to include this amount as additional taxable income.

Examples of Credits and Debts in the Inflation Adjustment

Let's now look at more detailed examples of what is considered a credit or a debt for the purposes of the inflation adjustment.

Credit Examples:

1. Accounts Receivable: If the company sells goods or services on credit, the amount of unpaid invoices at the end of the month is considered a credit.
2. Loans granted to third parties: If the company has lent money to another entity or person, this loan is a credit as long as it has not been repaid.
3. Investments in debt instruments: Investments in bonds, promissory notes, or certificates that generate interest are considered credits since the company has the right to receive the payment of the principal and interest.
4. Tax overpayments: If the company has tax overpayments, these are considered credits from the day after the tax return is filed until they are offset, credited, or refunded.
5. Financial receivables: Rights derived from financial derivative contracts, such as swaps or futures, are also considered credits.

Examples of Excluded Credits:

Not all rights to receive money or goods are considered credits for inflation adjustment purposes. Examples of exclusions include:

• Accounts receivable from shareholders or partners who are individuals or foreign residents, except in very specific cases.
• Income that is taxable only upon current receipt, such as some financial lease contracts.
• Cash on hand: Although technically an asset, it is not considered a credit for inflation adjustment purposes.

Examples of Debts:

1. Bank loans or loans from other financial institutions: Any loan or credit the company has received and not repaid at the end of the month is considered a debt.
2. Accounts payable to suppliers: If the company purchases goods or services on credit, accounts payable to suppliers are debts until they are settled.
3. Financial agreements: If the company has financial lease contracts, the debt is considered to be the amount still pending payment each month.
4. Taxes owed: Unpaid tax obligations (such as income tax or VAT owed) are considered debts until they are settled.
5. Borrowed capital: If the company receives a cash loan or loan in kind, it will be considered a debt from the moment the capital is received.

Examples of Excluded Debts:

Not all obligations are considered debts for inflation adjustment purposes. Some exclusions include:

• Non-deductible expenses: Any debt derived from non-deductible expenses (such as certain personal expenses or non-deductible taxes) is not included in the calculation.

Conclusion

The annual inflation adjustment is recognized in the annual calculation as either deductible or taxable, depending on the case, and can have a significant impact.

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