Volume 6, Number 24, Page 2

New Tax Regime for Maquiladoras: Part 1 of 2

By John A. McLees, Mary C. Bennett, and Jaime Gonzalez-Bendiksen

Mexico and the United States have reached an agreement on a new tax regime for Mexican maquiladora companies and for the U.S. companies that use the processing services of a maquiladora. The agreement is intended to resolve the tax issues that have concerned U.S. companies during the past year as a result of Mexico’s initiative to impose its income tax on U.S. companies involved in the maquiladora industry on the ground that they have permanent establishments in Mexico.

The agreement responds to the industry’s concerns and to Mexico’s desire to increase its tax collections from this industry. It does so by shifting the extra tax burden to the Mexican maquiladora companies themselves. This overall agreement to shift increased tax collections to the Mexican companies takes into account the reality of both the U.S. foreign tax credit rules and the absence of meaningful standards for Mexico to use in determining how much income to attribute to a permanent establishment of a U.S. company in Mexico.

In reaching this agreement when they did, the two governments met a tight deadline posed by the looming effective date of January 1, 2000, of the Mexican statutory change that would have brought the new permanent establishment rules into effect. What remains is a process of reaching detailed agreements between the two governments on how the Mexican maquiladora companies will be required to compute their taxable income under the agreement announced on October 29. That agreement contains some details on how the Mexican companies should be taxed in the years 2000 through 2002, and it establishes general principles and a process of consultation for ironing out the remaining details for taxing the Mexican companies in those years and in later years.

In announcing the agreement Mexican officials expressed the hope that the United States and Mexico could resolve those details by the end of next year. Many in the industry have rightly pointed out that until that happens the continuing uncertainty about those outstanding issues will be a drag on new foreign investment in manu-facturing operations in Mexico.

If the two governments implement the agreement as it is drafted, the question of imposition of Mexican income tax on the U.S. companies on the grounds that they have permanent establishments in Mexico appears to be off the table. That is good news for the maquiladora industry and very good news for Mexico, which now has the chance to eliminate the uncertainty that had threatened to disrupt an industry that has been the driving force behind Mexico’s economic growth over the past five years.

While the new tax regime is likely to be much preferable to a permanent establish-ment regime for most U.S. companies, most companies will face some increases in their overall income tax burden as a result of this agreement, due to limitations on their ability to get a full foreign tax credit in the United States for the increased income taxes imposed on the maquiladoras and the 5 percent with-holding tax that will apply to the maquiladoras’ distributions of their after-tax profits as dividends to their parent companies. That will be a relatively minor issue for many companies, but it will loom much larger for U.S. companies with tax losses or excess foreign tax credits.

Companies will also need to consider the increases in mandatory profit-sharing liability of the maquiladoras to their employees that may follow from the increases in their taxable income. By transferring tax attributes of the U.S. companies to the maquiladoras, the intergovernmental agreement has the side effect of artificially increasing the maquiladoras’ mandatory profit-sharing liability.

It will be particularly important for the two governments to issue more detailed guidance as soon as possible about the transfer pricing methodologies that Mexico will apply in its transfer pricing rulings for the year 2000, so that the maquiladoras can intelligently address the choice that they will need to make early next year between the safe harbor and a transfer pricing ruling. They will also need to address new issues that arise from the agreement’s unique approach of using tax attributes of a U.S. company to compute the Mexican taxable income of a Mexican company. One such issue, discussed briefly below, is the question of how Mexico will take losses of the U.S. company into consideration in determining the Mexican income tax liability of the Mexican company.

The other important issue that must be addressed immediately is the question of how Mexico will implement this agreement. The issues addressed in the agreement arose from Mexico’s repeal, effective January 1, 2000, of a statutory provision (referred to as a “Transitorio”) that is also structured as an exemption for the foreign companies from having permanent establishments in Mexico if their maquiladora companies comply with certain transfer pricing rules. It is important that Mexico amend its law to enact the new rules providing U.S. companies with an exemption from having a permanent establishment in Mexico to replace the current statutory provision that expires at the end of this year.

This article discusses the overall structure of the intergovernmental agreement, specific rules that the agreement establishes for determining the taxable income of the maquiladoras, and some of the important new questions that the agreement leaves unanswered.

We also discuss briefly how companies should respond to the agreement, including the need to consider other alternatives for dealing with the tax risks. It is important to note that the alternatives set forth in the intergovernmental agreement are not the only alternatives available to maquiladoras and their U.S. affiliates for dealing with the permanent establishment issue. Many companies may find it more advantageous to restructure their maquiladora operations so as to eliminate the permanent establishment risk without requiring the maquiladora to bear the increased tax burden contemplated by the intergovernmental agreement.

Background

Maquiladoras are ordinary Mexican companies that operate under Mexico’s longstanding maquiladora program. That program was originally designed to reduce trade barriers to the development of export-oriented manufacturing operations in Mexico. The maquiladora program provides for exemptions from Mexican value added tax and customs duties on temporary importation of raw materials, assemblies, and manufacturing equipment to be used in connection with the operations of a Mexican maquiladora company.

Most maquiladoras operate under manufacturing services agreements with their U.S. affiliates or other foreign companies, commonly known as contract manufacturing arrangements. Under those arrangements the U.S. company typically owns the work in process, the final products, and the machinery and equipment used in the manufacturing process.

Mexico implemented arm’s length transfer pricing rules for those intercompany transactions in 1994 and 1995, with the cooperation of the maquiladora industry. The result was that Mexico now taxes the maquiladoras themselves like any other Mexican company.

This past year Mexico departed from its past policy of relying solely on tax collections from the maquiladoras themselves, based on principles of arm’s length pricing. It sought to supplement its tax collections from the maquiladoras by imposing its income tax on an undefined portion of the income of the U.S. companies that use the processing services of a maquiladora. The industry vigorously opposed that initiative. The agreement that the two governments announced on October 29 is intended to resolve that controversy.

The agreement was the result of lengthy discussions between officials of the office of tax policy in Mexico’s Ministry of Finance and Public Credit and officials of the Tax Treaty Division of the office of the assistant commissioner (international) of the U.S. Internal Revenue Service. Officials in the office of the international tax counsel in the U.S. Department of the Treasury also participated in the discussions that led to this rather unusual and creative agreement.

The agreement reflects a degree of sympathy on the part of the U.S. Internal Revenue Service with the fundamental position of the Mexican government that it needs to get more tax revenue from the maquiladora industry. The agreement substantially increases the amount of taxable income that Mexico can require a Mexican maquiladora company to report without objection from the United States to the transfer price required to achieve that result.

That sympathy for the Mexican position was already apparent in the provisions of the Mexico-U.S. income tax treaty, which was negotiated in 1992 and ratified in 1993. The treaty includes a unique provision that in effect invited Mexico to treat U.S. companies involved in the maquiladora industry as having a permanent establishment in Mexico.1

That treaty provision may have given the false impression that Mexico could realistically increase its tax collections from the industry through a program of taxing the U.S. companies, or that it would be a routine matter for Mexico to implement a tax regime based on taxing the U.S. companies on income attributable to permanent establishments in Mexico. In fact Mexico’s decision to treat hundreds or thousands of U.S. companies involved in an entire industry as having permanent establishments based on their current manner of doing business was virtually unprecedented.

U.S. companies pointed out that they would not find it acceptable to operate in a manner that caused them to have permanent establishments in Mexico any more that they would find that to be acceptable in any other country. Therefore, if Mexico had pursued this initiative, it would have disrupted the maquiladora industry, which is central to Mexico’s manufacturing sector and to the economies of the border states in both Mexico and the United States. The problems involved in taxing the U.S. companies are compounded in this case by the fact that any income of the U.S. company that Mexico chooses to tax on the basis that its arrangement with a maquiladora gives rise to a permanent establishment would be subject to the risk of systematic double taxation by both the United States and Mexico.

Fortunately both governments chose to work toward a resolution that avoids systematic double taxation and that reduces the uncertainty that made Mexico’s permanent establishment initiative so unacceptable, rather than simply acting as though it was the responsibility of the other government to solve the problem.

Overview of the Agreement

The main terms of the agreement are as follows:

The United States has agreed that Mexico may impose an abnormally high level of tax on the Mexican maquiladora companies themselves. The United States will grant a deduction to U.S. companies for higher payments to their affiliated maquiladoras to enable the maquiladoras to meet the standards that the two governments establish for Mexico to use in taxing the Mexican companies.

Mexico in turn has agreed that, if the Mexican company meets those standards, Mexico will not treat the U.S. company as having a permanent establishment in Mexico, and Mexico will grant an asset tax exemption to the U.S. company, subject to certain limitations based on the portion of its output that is delivered to customers in Mexico.

The two governments have agreed on some of the details of the methods that Mexico can require maquiladoras to use to compute their Mexican income tax for the years 2000, 2001, and 2002. For the U.S. affiliate to be exempt from Mexican income tax and asset tax in those years, the Mexican company will need to make a submission by April 30 or May 31 either (1) stating that it will have taxable income in excess of a new safe harbor threshold that is set forth in the intergovernmental agreement or (2) applying for a Mexican transfer pricing ruling (an advance pricing agreement or APA) for that year. The agreement provides that in issuing those APAs Mexico may use a transfer pricing methodology that takes into consideration assets actually owned and provided by the U.S. company in determining the transfer price to be received by the Mexican company.

The agreement states that the two governments contemplate issuing additional guidance to implement the terms of this agreement. Further guidance will probably be necessary, for example, to define how Mexico may take into consideration the foreign-owned assets in the new transfer pricing policies that it will apply in rulings to be issued to the Mexican companies under the agreement.

The agreement establishes an ongoing process of consultation, starting next year, through which the governments will work out specific agreements on the details of the methods that Mexico can require maquiladoras to use to compute their Mexican income tax in 2003 and later years.

The United States has already agreed that the long-term rules for determining the abnormally high level of tax that Mexico will be able to impose on the Mexican companies will take into account the need to increase the taxable income of the Mexican company to compensate for Mexico’s loss of tax revenue that it would have the power to collect from the U.S. companies in the absence of the agreement. The agreement states that, “During such discussions [on the permanent rules to be applied to the Mexican companies], due regard should be given to Mexico’s right to tax [the U.S. companies] in accordance with Article 5 of the Treaty.” Agreement on this general principle makes it very likely that the two governments will agree on the details of the tax treatment of the Mexican companies that will be required to implement the agreement for years after 2002.

The agreement expressly limits the subject of the ongoing talks between the two governments to consultations regarding the methods that Mexico will use to tax the Mexican companies, which are referred to in the agreement as “maquila enterprises.” The governments went out of their way to make clear that the agreement does not contemplate discussions about implementing any new initiative under which Mexico might once again attempt to tax the U.S. companies. The agreement states that, “It is our mutual understanding that this agreement in no way constitutes measures for attributing income to a permanent establishment.”

The agreement covers only maquiladora operations. It does not address operations conducted by Mexican companies under Mexico’s alternative program for temporary importation of assemblies and machinery and equipment, known as the PITEX program. It appears likely that this exclusion was deliberate and that the governments have decided that going forward they will confine their attention to maquiladora companies and their U.S. affiliates. If so, many Mexican companies that now operate under Mexico’s PITEX program will need to consider converting their status to that of a maquiladora. n

Look for the second part of this series in the next issue of the Inter-American Trade Report.

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 Exportation, A.C. (CNIME) and to the Maquiladora/PITEX Tax Advisory Group. Mary C. Bennett is a tax partner in the Washington, D.C., office of Baker & McKenzie. Jaime Gonzalez-Bendiksen is the senior tax partner at Baker & McKenzie in Juarez, Tijuana, and Monterrey.

This article originally appeared in the November 8, 1999, issue of Tax Notes International. Reprinted with permission, Tax Analysts, 1999.