Volume 6, Number 6, Page 1

Mexico Moves to Tax the Income and Assets of U.S. Companies with Maquiladora or PITEX Operations

by John A. McLees and Jaime Gonzalez-Bendiksen

Mexico is implementing fundamental changes in the manner in which it taxes U.S. manufacturing companies that engage in shared production activities with companies in Mexican. Its objective appears to be to supplement the tax it collects from the Mexican company, as a result of transfer pricing rules it has implemented over the past several years, with substantial additional tax collections from the U.S. company itself.

Mexico has chosen to pursue its objective of increasing tax collections from this sector by expanding the circumstances in which a foreign company will be treated as having a permanent establishment in Mexico for Mexican income tax purposes as a result of using the processing services of a Mexican maquiladora or PITEX company. Finding that a foreign company has a permanent establishment in Mexico will also result in the imposition of Mexican asset tax on the foreign company on the value of the machinery and equipment, inventory, and other assets that it owns in Mexico.

Mexico has enacted these changes for the maquiladora industry through a repeal, with a delayed effective date of January 1, 2000, of a statutory provision that has generally limited the circumstances in which a foreign company’s participation in such arrangements with a maquiladora would cause it to have a permanent establishment in Mexico. The rule that is now scheduled to expire at the end of this year has provided that a foreign company that makes arm’s-length payments to a maquiladora will generally not have a permanent establishment in Mexico unless it has a fixed place of business in Mexico. On October 15, 1998, Mexico revoked a temporary regulation that had contained similar protection for the foreign companies using the processing services of a PITEX company. (For prior coverage, see Tax Notes Int’l, Nov. 9, 1998, p. 1405, or Doc 98-32802 (5 pages).)

The changes primarily affect U.S. companies. Mexico’s tax treaties with other countries themselves generally limit the circumstances in which Mexico may impose its income tax on the net income of a company from a treaty country to situations in which the foreign company has a fixed place of business in Mexico (or in which it has a dependent agent in Mexico that has and habitually exercises the power to conclude contracts on its behalf). Mexico appears to expect, however, that the amendment to the Mexican law will enable it to increase its tax collections from U.S. companies because Article 5 of the Mexico-U.S. income tax treaty provides that a U.S. company will have a permanent establishment in Mexico for purposes of the treaty if it owns goods or merchandise in Mexico that are processed by a dependent agent using assets provided directly or indirectly by the U.S. company.

Most U.S. companies organize their maquiladora or PITEX operations in that way. Therefore, unless the prior rules are restored, Mexico will most likely assert that the combined operation of the Mexican income tax and asset tax will result in substantial Mexican tax liability for most U.S. companies that use the processing services of a maquiladora or a PITEX company. Resolving the resulting disputes over the application of the permanent establishment rules under the treaty and under Mexican law, as well as disputes over the amount of income to attribute to any such permanent establishment, will be expensive and disruptive. Thus, if the old rules are not restored, most companies will be forced to consider alternatives for restructuring their maquiladora operations in a way that avoids having a permanent establishment in Mexico.

It is important to note that imposing Mexican tax on a U.S. company’s income in these circumstances would generally result in double taxation of the same income by Mexico and the United States because the United States would not generally grant a foreign tax credit for the Mexican income tax in these circumstances. That follows from the manner in which the IRS interprets the source-of-income rules under Section 863(b) of the Internal Revenue Code. While there is limited authority on this issue, we understand the IRS position to be that a U.S. company does not generate foreign source income from the sale in the United States of products manufactured using the services of a maquiladora company under the rules set forth in Treas. reg. section 1.863-3.

According to the IRS such a U.S. company does not have a productive activity of its own outside the United States even if it owns substantial productive assets in Mexico and even if the maquiladora’s activities only account for a small portion of the value added in Mexico under normal transfer pricing principles. Under that interpretation of the U.S. regulations, the U.S. company is not able to treat any of the income that is allocable to the production activity as foreign source income even if most of its productive assets are located outside the United States.

The National Council of the maquiladora industry, the Consejo Nacional de la Industria Maquiladora de Exportation, A.C. (“CNIME”), is actively engaged in discussions with the Mexican tax authorities in support of its proposal that Mexico reinstate the permanent establishment rules that it has recently repealed. [Editor’s note: For more information, see the position paper that CNIME presented to Mexico’s Undersecretary of Revenue Tomas Ruiz on February 23, 1999, on the Adverse Consequences of Mexico’s Attempt to Tax the Income of U.S. Companies That Use the Services of a Maquiladora or a PITEX Company. The full document can be found on-line at http://www.natlaw.com/pubs/smmxtx4.htm ]

All U.S. companies that use the processing services of a maquiladora or a PITEX company need to evaluate the consequences for their operations of the uncertainty and extra tax and administrative costs that are likely to follow from Mexico’s changes in the permanent establishment standards if the old rules are not restored. They also need to evaluate the consequences of the alternatives that may be available to a U.S. company for restructuring its operations in order to avoid a permanent establishment in Mexico and the resulting additional tax and cost exposures. It would be useful for U.S. companies to make their conclusions known to the Mexican authorities if they determine that the new rules would have serious negative consequences for the competitiveness of their Mexican operations or the Mexican operations that they plan for the future.

Earlier this month, the Mexican tax authorities issued a press release that in effect invites such input. The release reaffirmed Mexico’s intention not to cause double taxation and stated that the authorities wish to minimize the disruption in the maquiladora industry from changes in its tax rules. Thus far, however, the tax authorities have not acknowledged that the new permanent establishment rules will have any negative impact, and there has been no indication that the tax authorities are considering a change in the current law or regulations that would restore the prior rules.

Tax Exposures

In evaluating the effects of Mexico’s recent tax changes for the maquiladora and PITEX industries, it is important to take into account the effects of the Mexican asset tax, in addition to trying to assess the amount of the Mexican income tax liability that the U.S. company could incur if it is required to attribute income to a permanent establishment of the U.S. company in Mexico.

Mexico imposes its asset tax on foreign companies at a rate of 1.8% on assets used in business activities in Mexico. For example, a foreign company that owns assets in Mexico whose depreciated value under Mexican principles would be 100 million Mexican pesos (approximately US$ 10 million) would have an annual asset tax liability of 1.8 million pesos (approximately US$ 180,000). This simple example does not illustrate the controversy that may arise over what assets of the U.S. company are attributable to the permanent establishment. Most likely these will include the inventory and machinery and equipment that the U.S. company owns and uses in Mexico in connection with the maquiladora or PITEX operations. (For prior coverage of the operation of the Mexican Asset Tax, see Tax Notes Int’l, February 1991, p.117.)

Because asset tax liability is reduced by a taxpayer’s income tax payments, and because the asset tax itself is not a creditable tax for purposes of the U.S. foreign tax credit, a U.S. company with a permanent establishment in Mexico may be forced to allocate sufficient income to the permanent establishment to generate the Mexican income tax needed to offset the asset tax. Thus, the asset tax will result in the imposition of Mexican income tax on a U.S. company even when it shows a loss for U.S. tax purposes.

On March 3, 1999, Mexico issued temporary regulations extend to 1999 the existing rules that provide for a conditional exemption from Mexican asset tax for a foreign company that does not have a permanent establishment in Mexico. That exemption applies to assets that the foreign company owns in Mexico that are used in connection with a maquiladora operation, provided that the foreign company meets certain notice requirements and that either (1) it obtains a ruling from the Mexican tax authorities that it is paying an arm’s-length price to the maquiladora or (2) it falls into a specified safe harbor of having taxable income equal to at least 5% of the total value of the assets used in Mexico in connection with those operations.

There is no such asset tax exemption for foreign companies dealing with a PITEX company, however, and it is likely that Mexico will not extend its conditional asset tax exemption for foreign companies that deal with maquiladoras beyond 1999 if it continues to pursue its current objective of increasing the Mexican tax burden on U.S. companies using the processing services of a maquiladora for the year 2000 and future years. Companies will need to take the possible repeal of this rule into account in evaluating their alternatives for restructuring their arrangements with their maquiladora companies in Mexico for the year 2000 and future years.

For a more complete discussion of Mexico of the rather complex tax regime that Mexico has applied since 1995 to U.S. and Mexican companies participating in the maquiladora industry, see Tax Notes Int’l, May 8, 1995, p. 1619, or 95 TNI 88-1; and Tax Notes Int’l, July 24, 1995, p. 183, or 95 TNI 140-1.

Administrative Burden

The industry position paper that is reproduced below discusses the extraordinary administrative burden that will accompany any attempt by Mexico to implement a tax regime for maquiladora and PITEX operations based on a determination that the U.S. companies have a permanent establishment in Mexico. For most companies this would include the cost of resolving significant ambiguities in what constitutes a permanent establishment under the tax treaty and under Mexican law, the extraordinary costs involved in determining how much income to attribute to a permanent establishment under the methodology that Mexico has said it will employ to make such attribution, and the cost of restructuring maquiladora operations in response to the new rules.

Many companies are likely to dispute the views of the Mexican tax authorities about what constitutes a permanent establishment under the treaty and under Mexican law. Disputes over the application of the permanent establishment rules of the Mexico-U.S. treaty may extend to competent authority proceedings. It remains to be seen, however, what position the U.S. authorities would take on these issues. In Mexico the competent authority is the Administrador Central de Normatividad de Impuestos Internos of the Administración General Jurídica de Ingresos, Mr. Mauricio Martínez-D’Meza. For a discussion of arguments that taxpayers would have in supporting a conclusion that they do not have a permanent establishment under the new rules, see Tax Notes Int’l, Nov. 23, 1998, p. 1566, or Doc 98-33959 (4 pages).

The industry position paper points out that administrative costs are an important factor for any shared-production activity, large or small, and that small changes in costs can have a big impact on a company’s decision of where to locate such operations. While cost considerations are important for any business, they have a larger impact on the fine-tuned economic relationships involved in cross-border sharing of different elements of a single productive activity.

Profit Sharing Costs

Another additional cost for some companies from a determination that the U.S. company has a permanent establishment in Mexico will be the exposure to liability for mandatory profit sharing. If a U.S. company has employees who are working in Mexico in connection with a maquiladora or PITEX operation, then any attribution of income to a permanent establishment of that company related to that operation would also expose the company to the risk of liability for mandatory profit sharing equal to approximately 10% of the income so attributed. The profit sharing amount would be shared among such employees in the manner set forth in the Mexican Labor Law. In many cases the profit sharing payments would not be deductible in determining the U.S. company’s Mexican income tax liability.

Restructuring Maquiladora and PITEX Operations

U.S. companies will need to consider changing the structure of their maquiladora or PITEX operations if Mexico does not reinstate its old permanent establishment rules. The issues that they will need to address include the following:

• Which party should own the inventory being processed in Mexico?
• Which party should own the machinery and equipment used in Mexico in connection with the maquiladora or PITEX operations?
• What should be the terms on which the U.S. company obtains the participation of the Mexican company in its manufacturing activity?
• What kind of Mexican company should they use in the future?
• How should that company be owned?
• What is the desired characterization of that Mexican company for U.S. federal income tax purposes?
• What entity should employ the individuals that are working in Mexico in connection with a maquiladora or PITEX operation?

In effect most US companies will need to reconsider their corporate, transactional and pricing structures for their existing and future maquiladora or PITEX operations from the bottom up. Unless Mexico changes its current law, that restructuring will need to be in place by the end of 1999 in order to prevent the US company from the risk of having a permanent establishment in Mexico, starting at the beginning of the year 2000. Of course, as mentioned above, U.S. companies do not have until the end of 1999 to consider restructuring their PITEX operations, for which the new less favorable rules took effect on October 15, 1998.

In many cases a company’s alternatives will be limited by significant U.S. tax costs that the company would incur if it were to undertake the transactions required to move to a particular alternative structure for its maquiladora operations. In addition, alternatives that a particular U.S. company can implement without prohibitive U.S. tax cost will in many cases create additional Mexican tax exposures and uncertainties. Any alternative that increases a Mexican income tax imposed on the U.S. company’s Mexican affiliate will also have the potential of increasing the Mexican company’s liability for mandatory profit sharing, which for most such companies will not be a deductible expense.

Each U.S. company will need to undertake a balancing of competing factors in order to identify the alternative that minimizes the additional tax and profit sharing liability. Most companies will, however, face an increased tax and administrative burden if Mexico pursues its current strategy of increasing tax collections from U.S. companies with manufacturing operations in Mexico. n

John A. McLees is a partner in the Chicago office of Baker & McKenzie and advisor to the fiscal committee of the Consejo Nacional de la Maquiladora de Exportacion, A.C.

Jaime Gonzalez-Bendiksen is the tax partner at Baker & McKenzie in Juarez, Tijuana and Monterrey

This article was previously published in Tax Notes Int’l, March 22, 1999, p. 1183.