Volume 5, Number 23, Page 1

Tax Risks for U.S. Companies With Maquiladoras

by John McLees of Baker and McKenzie in Chicago

Mexico recently adopted more aggressive rules for taxing foreign companies that manufacture products in Mexico under Mexico’s PITEX program. As a result of this change, most U.S. companies contracting with a Mexican PITEX company will be required to pay Mexican income tax on a portion of their income from the sale of goods processed in Mexico.

The amount subject to Mexican tax will be the amount of taxable income that Mexico concludes is attributable to a permanent establishment of the U.S. company in Mexico. The result for most U.S. companies now using the PITEX program is likely to be new administrative burdens and significant exposure to double taxation unless the old rules are restored.

The importance of analyzing these new tax burdens extends beyond companies using the PITEX program. The Mexican tax authorities have stated their intention of making the same change to permanent establishment rules applicable to foreign companies making use of Mexico’s maquiladora program. Therefore, virtually all U.S. companies engaging in shared production activities with a Mexican company must carefully analyze the impact of the proposed new rules on their overall income tax burden and on the administrative cost of doing business in Mexico.

If Mexico decides to impose its income tax on a U.S. company without a fixed place of business in Mexico, solely because it owns productive assets in Mexico used in processing products owned by the U.S. company, it will have abandoned a cornerstone of the overall tax treatment of the maquiladora industry to which the Mexican tax authorities agreed to earlier. This system for taxing maquiladora operations was adopted in connection with the maquiladora industry’s agreement to cooperate with the Mexican government in introducing normal transfer pricing rules to determine the taxable income of the maquiladora companies themselves.

Moreover, use of the Mexican permanent establishment rules in this way is one of the most administratively expensive alternatives that Mexico could adopt for raising additional revenue from the industry, both for the industry and the government itself.

It remains to be seen how such a fundamental change in the Mexican tax treatment of the industry will affect the growth of the maquiladora industry, which has been essential to maintaining the stability of the Mexican economy over the past several years.

The New PITEX Disadvantage

In mid-October Mexico revoked a key rule that had limited the circumstances in which it imposed Mexican income tax on foreign companies manufacturing products in Mexico through contracts for manufacturing services with Mexican companies qualifying under the PITEX program. The change will result in Mexican income tax liability for most such U.S. companies because of (1) the unusual breadth of the “permanent establishment” rules that apply under Mexican domestic law and (2) the special provision of the U.S-Mexico income tax treaty granting Mexico unusually broad power to tax U.S. companies’ income from the sale of products processed by a Mexican company using machinery and equipment owned by the U.S. company. Most U.S. companies that contract with a PITEX company or a maquiladora operate in such manner.

The revoked rule was contained in section 3.1.4 of Mexico’s temporary tax regulations (or Miscelanea) for 1998. It protected foreign companies dealing with an affiliated or unaffiliated PITEX company from the application of Mexico’s unusually broad standards for concluding that such foreign company has a permanent establishment. In effect, that temporary regulation had provided that a U.S. company paying an arm’s-length price for the services provided by a PITEX permit would be subject to Mexican income tax only on income from sales of the products processed by the PITEX company to the extent the income was attributable to a fixed base in Mexico or to activities of a PITEX company constituting a dependent agent with the power to conclude contracts on behalf of the U.S. company.

This is similar to the Mexican statutory rule still applicable to U.S. companies contracting for manufacturing services from a maquiladora company. For the maquiladora industry, this rule arises under a special statutory provision that for several years applied generally to foreign companies but that in 1997 was expressly limited to the activities of foreign companies that are undertaken through arrangements with maquiladoras. Previous reports have discussed the government’s proposal to change the statutory rule in tax legislation to be submitted to the Mexican Congress later this month.

This added Mexican income tax burden for those U.S. companies found to have a permanent establishment in Mexico under principles of Mexican law is separate from and in addition to the Mexican tax imposed on the Mexican company. The amount subject to Mexican income tax will be the portion of the U.S. company’s net income attributable to the Mexican permanent establishment.

Under the terms of the Mexico-U.S. income tax treaty, the determination of that amount should depend on a transfer pricing analysis separate from the transfer pricing analysis used to determine the price the Mexican PITEX company (or maquiladora) charges for manufacturing services. Paragraph 2 of article 7 of the treaty provides for the attribution (to the permanent establishment) of an amount of taxable income equal to what a hypothetical separate Mexican company would have earned if the U.S. company in question had established another separate Mexican company to own the assets used by the U.S. company in Mexico and to undertake the activities of the U.S. company in Mexico. The result will depend on all the facts and circumstances. It is likely, however, that a significant amount of taxable income could in some cases be attributed to such permanent establishment in the case of a U.S. company that owns a substantial amount of assets that are used in Mexico.

For the time being the recent change amounts to a potentially significant tax disadvantage for a U.S. company that has qualified its Mexican contract manufacturing company under the PITEX program, rather than under the maquiladora program. That disadvantage could disappear, however, if Mexico either restores the old treatment for the PITEX program or makes the same change for U.S. companies whose Mexican counterpart qualifies under the maquiladora program.

Mexico’s Permanent Establishment Standards

Whether a particular foreign company has a permanent establishment under the provisions of Mexican law will be contested if Mexico decides to eliminate its past limitations on the circumstances in which it will conclude that a U.S. company dealing with a PITEX company or a maquiladora will be treated as having a permanent establishment in Mexico.

A complete discussion of Mexico’s permanent establishment rules is beyond the scope of this article. It is important to note, however, that the grounds for finding a permanent establishment under Mexican law are substantially broader than those that generally apply under Mexico’s income tax treaties or other treaties based on the U.S. or OECD model treaties.

Mexico has chosen to interpret those treaties in accordance with established principles of interpretation of the OECD model income tax treaty, and, in most respects, the Mexico-U.S. treaty employs the standard definition of a permanent establishment set forth in the OECD model treaty. The OECD commentaries on the model treaty interpret those rules as giving rise to a permanent establishment for a company that is resident in a treaty country only to the extent that either (1) the company has a fixed place of business in the other treaty country or (2) a party acting in the other treaty country constitutes a dependent agent of the company and habitually exercises the power to conclude contracts on behalf of that company.

The references to independent contractors in the Mexico-U.S. treaty should be interpreted as establishing the conditions under which an independent agent in Mexico will be treated as a dependent agent for purposes of the above rules, so that its activities can constitute a permanent establishment of the foreign company (if the Mexican party has the power to conclude contracts on behalf of the U.S. company). By contrast, Mexican domestic law now expressly provides, in article 2 of the Mexican income tax law, that activities of an independent contractor will automatically constitute a permanent establishment of the foreign company if it is determined that the independent contractor engages in any of several broad and ambiguous categories of activities, including the following:

• It has a supply of goods or merchandise to be delivered on behalf of the foreign party ;
• It assumes risks on behalf of the foreign party;
• It acts under detailed instructions or general control of the foreign party; or
• It exercises activities that economically correspond to those of the foreign party and not to its own activities.

Mexico would most likely conclude that most maquiladoras engage in such activities.

In the case of a maquiladora or a PITEX company, the significance of this difference is largely that the rules that Mexico would apply in imposing its income tax on U.S. companies are substantially broader than the standards that should generally apply under the Mexico-U.S. treaty or any of Mexico’s other bilateral income tax treaties. As mentioned above, these normal treaty limitations do not apply directly in these circumstances because of the special power that the U.S.-Mexico treaty grants to Mexico. This enables Mexico to tax the income of U.S. companies that have assets in Mexico used by a party other than an independent agent to process products owned by the U.S. company.

Prospect of Double Taxation

This situation illustrates the importance of the U.S. source-of- income rules in determining whether a particular application of a foreign country’s taxing power will result in double taxation for a U.S. company. In short, foreign taxation of part of a U.S. company’s income will result in double taxation of that income when the United States treats that particular income as U.S.-source income for purposes of calculating the U.S. foreign tax credit limitation. In that case, the limitation will eliminate the U.S. foreign tax credit for a company whose tax credit for the foreign tax is not increased or decreased by virtue of a global tax situation that gives the company an overall effective foreign tax rate that is lower or higher than the U.S. rate.

In the situation presented here, the IRS interprets the U.S. source-of-income rules (in the regulations issued under section 863(b) of the Internal Revenue Code) as denying a U.S. company the benefit of foreign-source treatment for any part of the U.S. company’s income from the sale of products processed in Mexico using the manufacturing services of a PITEX company or a maquiladora. This is the case even if the U.S. company owns substantial assets in Mexico that it uses, along with the Mexican company’s manufacturing services, to process the goods. The position is based on the conclusion that such a U.S. company itself has no manufacturing activity in Mexico (unless the Mexican party providing the manufacturing services is a subsidiary that is structured in such a way that it is treated as a branch of the U.S. company for U.S. federal income tax purposes).

There is a strong argument that this conclusion makes no sense from an economic standpoint or from the standpoint of a reasonable interpretation of the IRS regulations themselves. It is far-fetched to say that a company that owns equipment that it uses to process products in the foreign country has no manufacturing activity in that country, even if it also uses a local manufacturing services provider to participate in the productive activity. Such a conclusion does not depend on attributing any of the activity of the Mexican party to the U.S. company. It should in no way be affected by a conclusion under foreign law that the U.S. company’s activity in the foreign country is not sufficient to give rise to a permanent establishment in the foreign jurisdiction.

Nevertheless, so long as the IRS rejects this interpretation of the U.S. source-of-income rules, there will be double taxation of that portion of the U.S. company’s income from the sale of products processed in Mexico that Mexico chooses to subject to Mexican tax as income attributable to a permanent establishment of the U.S. company in Mexico.

Administrative Costs of Dealing with the Changes

There are two reasons why the proposed change in the application of the Mexican permanent establishment rules would result in an extraordinary administrative burden for both U.S. companies processing or assembling in Mexico and for the Mexican tax authorities themselves.

The first arises from the problems presented in interpreting and applying the Mexican regulations to determine whether the U.S. company has a permanent establishment under Mexican law. Because such application of the Mexican permanent establishment rules will generally affect the U.S. company’s global income tax burden, the U.S. company will need to analyze the Mexican permanent establishment standards carefully. They will have ample incentive to challenge the application of those rules to their operations.

Under the Mexican rules outlined above, that analysis will depend on the application of relatively obscure questions such as whether the Mexican company is operating in the ordinary course of its business, whether the terms of the parties’ arrangements are similar to those that would be used by independent parties, whether the maquiladora engages in activities that economically correspond to those of the foreign party, whether the maquiladora should be treated as an agent of the U.S. company for this purpose, and if so, whether it is an independent agent.

Secondly, determining the amount of income attributable to a permanent establishment would in itself more than double the current administrative cost of applying Mexican tax rules to the operations of a maquiladora and its foreign affiliate. As mentioned above, such analysis would result in a separate transfer pricing analysis similar to that which is now required with respect to the compensation that each maquiladora and PITEX company receives from its foreign affiliate for its manufacturing services. The separate additional transfer pricing analysis would analyze the amount of income to be attributed to the permanent establishment. This would involve the same kinds of questions involved in determining the transfer price for the maquiladoras, but the analysis would take place in the much more confusing environment of a hypothetical additional Mexican company, without any price being decided between the two hypothetical units in the accounting records of the company.

It is doubtful that it is realistic to implement such a complex tax regime could be implemented, either for the companies involved or for the Mexican tax authorities themselves. Maquiladora operations are by definition cost-sensitive operations. Companies have shown sensitivity to costs in moving such operations from one country to another as costs of doing business swing up or down in various jurisdictions. With dollar production costs substantially down in Asia, compared with just a year or two ago, significant additional administrative costs in Mexico would undoubtedly cause some maquiladora operations to locate in other jurisdictions.

Other Possible Tax Changes for Maquiladoras

As previously reported, Mexico has also been considering another potential change in the tax treatment of foreign companies that own productive assets in Mexico and that contract with a maquiladora company for manufacturing services. That change would eliminate the asset tax exemption on assets used in connection with the operations of a maquiladora company for foreign companies that lack a permanent establishment in Mexico.

That exemption arises under temporary regulations that have been renewed in one form or another since the first enactment of the Mexican asset tax law 10 years ago. It is presently embodied in section 4.1 of Mexico’s temporary tax regulations for 1998. The exemption is now conditioned on meeting certain annual notice requirements and on obtaining rulings from the Mexican tax authorities that the U.S. company’s compensation to the maquiladora for its manufacturing services satisfies Mexico’s arm’s-length pricing standards.

Companies should not generally analyze the implications of this potential change in light of the possible application of the asset tax on the U.S. company. Rather they should consider the tax impact of such a change in light of the additional Mexican income tax burden that the U.S. company or the maquiladora company would incur as a result of changes in the structure of their transactions implemented to avoid the application of the asset tax on the assets owned by the U.S. company.

There are two different potential methods for eliminating the extra asset tax liability and substituting an additional income tax burden for either the U.S. company or the maquiladora.

First, under Mexican law, foreign companies, like other Mexican taxpayers, are entitled to offset Mexican income tax payments against any tentative asset tax liability. There are special rules in the Mexico-U.S. income tax treaty that have the effect of increasing the magnitude of that offset in the case of withholding tax paid by a U.S. company on lease payments from a Mexican company to the U.S. company for the use of those assets.

Therefore, most U.S. companies would be able to eliminate any Mexican asset tax that would be imposed as a result of the proposed change in the existing asset exemption for assets used in connection with maquiladora operations by changing the economic arrangement on which the assets are made available to the maquiladora from that of a free bailment to that of a lease. The Mexican income tax costs of that change would consist of (1) Mexican withholding tax of 10 percent on the lease payment and (2) the possibility of some increase in the Mexican income tax paid by the maquiladora company as a result of including that lease payment in its cost base in computing the transfer price paid to the maquiladora.

The extent to which the imposition of such a Mexican withholding tax would result in double taxation for the U.S. company would depend on factors including whether or not the U.S. company was still depreciating the U.S. assets on which it is receiving the lease payments. There would in this case, however, be no systematic double taxation caused by adverse U.S. source rules because the United States would likely treat payments received from a foreign party for lease of assets located in the foreign jurisdiction as foreign-source income for purposes of computing the U.S. company’s foreign tax credit limitation.

Alternatively, subject to some clarification of the rules by the Mexican tax authorities, it should be possible for a U.S. company to avoid any asset tax liability by having its maquiladora company exercise the election generally available under article 25 of the regulations under the Mexican asset tax law. That regulation allows a maquiladora to elect to treat U.S.-owned assets as its own for Mexican income tax purposes. This rule should allow the Mexican company to offset its income tax payments against the asset tax, just as they are entitled to offset the rest of their asset tax liability. Thus they should themselves be able to avoid the additional asset tax by charging a transfer price that generates sufficient taxable income in Mexico.

This result should accomplish the objective of the Mexican tax authorities because it would result in Mexico receiving total tax payments at least equal to the tax that would be imposed by the asset tax law on both the maquiladora and the U.S. company.

Whether this alternative approach results in double taxation depends on whether the transfer price that the maquiladora needs to receive to generate the income tax required to offset its increased asset tax burden is acceptable to the U.S. tax authorities under the U.S. transfer pricing rules. While this could be an issue for some companies, it is likely that many companies would determine this to be a relatively minor risk preferable to paying the Mexican withholding tax resulting from restructuring its arrangements for providing its productive assets from a free bailment to a lease.

It is important to note that any increase in a U.S. company’s total income tax burden resulting from the elimination of the asset tax exemption for foreign-owned assets used in connection with maquiladora operations would be partially offset by a substantial reduction in the administrative costs of complying with the Mexican tax rules for such operations. This is because that exemption is now available only to U.S. companies that have received a ruling from the Mexican tax authorities that the compensation paid to the maquiladora satisfied Mexican arm’s-length pricing standards. If Mexico should decide to use its asset tax to increase income tax collections from the maquiladora industry in this manner, there would be many fewer companies finding it necessary to obtain a Mexican transfer pricing ruling.n

John McLees is a partner with Baker & McKenzie in Chicago.