Volume 6, Number 25, Page 2

The New Tax Treatment of the Mexican Company

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

For taxable years 2000 through 2002, the United States and Mexican governments have agreed that a maquiladora will need to choose either one of the following:

a. Meet a specified minimum threshold for its taxable income, requiring the maquiladora to have taxable income representing at least the higher of:

i. 6.9 percent of the value of the assets used in the maquila activity during that year (whether owned by the maquiladora or the U.S. company) and

ii. 6.5 percent of the deductions (operating cost and expenses) of the maquiladora for that year, or

b. Secure an Advanced Pricing Agreement (APA) from Mexico that will take into consideration the assets (including inventory) owned by the foreign principal and used in the maquila activity. (Maquiladoras that have applied for or secured an APA that covers the year 2000 or a subsequent year must either comply with the safe harbor for that year or request a new APA for that year under these new standards).

This choice is much like that available to maquiladoras under existing rules, which provide for an asset tax exemption for a U.S. company that owns assets used in Mexico in a maquiladora operation if the maquiladora has income in excess of a safe harbor threshold or if the maquiladora obtains a transfer pricing ruling. The main difference is that the taxable income of most maquiladoras will be substantially higher than it is now, either under the new safe harbor or as a result of the new transfer pricing methodology that Mexico will use in issuing transfer pricing rulings for maquiladora operations.

There are also new tighter deadlines for maquiladoras to give notice of their choice to satisfy the safe harbor or to obtain a transfer pricing ruling. The agreement provides that, “The application (full submission) for opting for either [alternative] must be made no later than May 31st for those taxpayers that have not previously applied for an APA; otherwise, the application must be filed no later than April 30.”

The first matter that must be clarified about this statement is what is meant by a “full submission.” In 1999 and past years maquiladoras have faced a deadline of May 31 to file a notice that the maquiladora’s taxable income would exceed the safe harbor threshold for the year or that it would seek a transfer pricing ruling for that year, but those seeking a ruling had until later in the year to file a ruling request. If the mention of a “full submission” in the intergovernmental agreement means that Mexico intends to require maquiladoras to make a full application for a transfer pricing ruling supported by a transfer pricing study by May 31, or April 30 in the case of companies that have previously applied for an APA, it should make that clear. Such a deadline would be hard to meet for many companies, particularly under the current conditions of uncertainty as to how Mexico will change its transfer pricing ruling policy to “take into consideration” the U.S.-owned assets.

Each maquiladora will be entitled to choose either the new safe harbor or a transfer pricing ruling for the year 2000, whether it elected the old safe harbor or a transfer pricing ruling or made no election at all in 1999 and past years. It will be important for Mexico to confirm in addition that a maquiladora will make its choice between the two alternatives separately for each tax year and that it will be able to change back and forth between the safe harbor and a transfer pricing ruling from year to year. As Mexico and the United States now appear ready to enshrine the safe harbor threshold as a permanent feature of the tax regime for the maquiladora industry, there is no apparent reason that a maquiladora should, for example, be prevented from changing back to the new safe harbor for a tax year after it has chosen to obtain a transfer pricing ruling under the new transfer pricing policies in a prior year.

1. The New ‘Safe Harbor’ Rules

As before, the safe harbor threshold is expressed as a minimum amount of taxable income, and one prong of the new safe harbor is similar to the old safe harbor rule in that it is defined as a percentage of the assets used in Mexico, whether owned by the maquiladora or the U.S. company. That percentage has increased from 5 to 6.9 percent, which will in itself result in a significant increase in Mexican income tax liability for some maquiladoras.

More importantly, the safe harbor threshold has been transformed into the greater of that amount or 6.5 percent of the maquiladora’s deductions for operating costs and expenses. The agreement is quite careful in defining the deductions to be taken into account for this purpose: “For these purposes, costs and expenses means all ordinary operating expenses, but does not include extraordinary or non-operating items, such as financing costs, exchange gains and losses or casualty losses, as defined by Mexican tax law and Mexican GAAP.”

The addition of this second prong to the calculation of the safe harbor threshold will greatly increase the minimum taxable income required for a labor-intensive maquiladora operation, meaning one that involves relatively few assets owned by either the maquiladora or the U.S. company compared to the value of the processing that is performed by the maquiladora company. That will tend to drive labor-intensive companies toward consideration of getting a transfer pricing ruling or toward avoiding these new rules altogether by transferring the machinery and equipment to the Mexican company.

2. The New Standards for Obtaining a Mexican Transfer Pricing Ruling

Initially at least, more capital- intensive maquiladora operations may be driven in the opposite direction, toward using the safe harbor rather than subjecting themselves to the uncertainty of how Mexico will implement its new right to take into consideration the foreign-owned assets in the transfer pricing methodology that it applies in issuing such rulings. Some capital-intensive operations will consider the alternative of avoiding the permanent establishment issue altogether without resorting to the new rules by transferring the machinery and equipment to the Mexican company, but that alternative involves potentially significant disadvantages for a -capital-intensive operation.

It is important that Mexico clarify as soon as possible how it plans to take the foreign-owned assets into consideration in its new transfer pricing policies. This topic should be high on the list of matters to be covered in the ongoing consultations between the two governments, so as to minimize the possibility of controversy and uncertainty about how the foreign-owned assets should be taken into account. One can imagine interpretations of this very general standard that would not be acceptable to the United States, and it seems likely that the two tax authorities will try to deal with those potential problems in advance through continuing discussions of how Mexico should take the foreign-owned assets into consideration in its new transfer pricing ruling policies for maquiladora operations.

The agreement itself begins that process with a lengthy discussion of what it might mean for Mexico to take into consideration the foreign-owned assets. It states that:

“The reference to ‘consideration’ of assets is not intended to restrict taxpayers to the use of the return on assets Profit Level Indicator (PLI). Rather, it is intended to provide flexibility to taxpayers to negotiate the appropriate return from the maquila activity, using a methodology or (PLI) that might be more appropriate to its facts and circumstances than the safe harbor described in paragraph 2(a).”

That is, although assets will be “considered”, a company would have an opportunity to demonstrate that, on the particular facts of its case, the activities conducted in Mexico would support a return on either costs or assets (as appropriate) and the return may be less than the return called for in the safe harbor. Under appropriate circumstances, a company could demonstrate that certain costs or assets (e.g. idle machinery and equipment or land not being used for manufacturing activities) should in fact generate no return. This would also imply that for purposes of the cost plus, the foreign assets will be taken into consideration in determining an appropriate plus.

Presumably much of the ongoing discussion between the two governments on this issue will consist of interpreting those statements and developing them into a concrete set of alternatives for maquiladoras and their advisors to use in applying for APAs from the Mexican tax authorities. If so, this will be a useful process because it could provide the necessary bilateral guidance without requiring each company to engage in the cumbersome process of obtaining a bilateral APA.

One of the most important issues that needs to be addressed in implementing this new tax regime is to attach the appropriate significance to a U.S. company’s losses for U.S. tax purposes in determining the Mexican tax treatment of the Mexican company. There is a strong argument that if the Mexican company is required to share the profits of the U.S. company through the fiction of taking the U.S. company’s assets into account in determining the income of the Mexican company, then the Mexican company should also share in the U.S. company’s losses during periods in which the U.S. company has a loss for tax purposes.

Procedurally, it will also be important for the United States to consider streamlined procedures for a U.S. company to use in implementing transfer pricing adjustments after the fact that are required to allow conformance with the new safe harbor threshold or to meet its obligations under a transfer pricing ruling issued by the Mexican tax authorities on the terms developed under the intergovernmental agreement.

A full discussion of the administrative issues arising under the transfer pricing alternative or the new safer harbor threshold is beyond the scope of this article. Both, however, will clearly pose many of the same problems that the old safe harbor has presented to companies in the past, such as the difficulties some maquiladoras have experienced in determining the Mexican pedimento (bill of lading) value of machinery and equipment imported in prior years, as is required under the Mexican rules. The section of the agreement on transfer pricing rulings states that, “The tax authorities will take into consideration any administrative concerns that could arise in valuing foreign owned assets”; one hopes that this will apply equally in connection with calculating the safe harbor threshold.

The New Permanent Establishment Exemption

The agreement contains a blanket exemption from permanent establishment status for U.S. companies whose maquiladoras meet the agreed standards for calculating their taxable income or determining their transfer prices with their foreign affiliates. This clarifies a matter that has raised concerns under the current statutory rule. Mexico has applied the current rule as though it created a blanket exemption from permanent establishment status for a qualifying company, but technically the rule could have been interpreted somewhat more narrowly.

It is also important to note that Mexico’s agreement to exempt U.S. companies from permanent establishment status and the asset tax, and the agreement of the United States to provide for an increase in the Mexican tax burden on the maquiladoras, while structured as an explicit firm agreement for a three-year period, implicitly reflects an agreement in principle to continue that general compromise in some form thereafter. This is apparent from the commitment to engage in discussions beginning next year relating exclusively to Mexican taxation of the Mexican companies, and not to discuss potential Mexican taxation of the U.S. companies. The two governments have reached a general agreement to allow Mexico to impose a higher income tax burden on the maquiladoras in exchange for Mexico’s agreement not to tax the U.S. companies, and they have established an ongoing process of consultation to define the details that remain to be worked out as to how the Mexican companies will be taxed, both for the years 2000 through 2002 and for later years.

The New Asset Tax Exemption

The exemption for the U.S. companies from the Mexican asset tax carries over a limitation from existing Mexican regulations. That limitation preserves the application of the asset tax to the U.S. company in whole or in part if the maquiladora uses the U.S. company’s assets in whole or in part to produce goods that are delivered to parties in Mexico. The agreement provides that “the foreign resident will be exempt from the Mexican asset tax on its assets used by those enterprises [the maquiladoras], in that proportion in which such assets are used for the export of goods included in the maquila program authorized by Mexico’s Trade Department.”

Whether or not there is a legitimate rationale for that limitation under existing regulations, it has no place in the new tax regime for the maquiladora industry. The continued imposition of the asset tax on the U.S. company based on the foreign-owned assets is a new example of double taxation, as the new rules presuppose that the maquiladora is earning a return on those same assets, both under the new safe harbor and under Mexico’s new transfer pricing ruling policy. This is no less true because the double taxation will occur only in connection with the use of those assets in production of products for the Mexican market.

Continued imposition of the asset tax on U.S. companies under these circumstances would be contrary to the underlying rationale of the asset tax, which is to impose an alternative tax to the extent that taxpayers are not paying the proper level of income tax.

In the past Mexico has cited political reasons for such a rule, namely the need to respond to the concerns of other Mexican companies that the maquiladora industry should not receive subsidies in its production for the domestic market. There appears to be no legitimate basis for any such concern under the new tax regime for the maquiladora industry, given that the maquiladoras will be paying an abnormally high level of tax to take into account the involvement of nontaxable foreign companies and foreign-owned assets.

It appears that maquiladoras can elect to treat such foreign- owned assets as their own for purposes of the asset tax, under Article 25 of the generally applicable asset tax regulations, so as to relieve the U.S. company of the asset tax liability. Those regulations should be interpreted to provide for an election by the maquiladora to treat those assets as assets of the maquiladora for all purposes of the asset tax, including the right of the maquiladora to credit the maquiladora’s income tax against that additional asset tax liability. If interpreted in this manner, this regulation will deal effectively with the double taxation problem that has been created by the recent agreement.

Overall Implications of the Agreement

The two governments have rightly concluded that this agreement largely eliminates the problem of systematic double taxation that could have resulted from Mexico’s initiative to impose its income tax on U.S. companies. This is because Mexico will be taxing only the Mexican maquiladora company, and because the United States will grant a deduction to the U.S. affiliate for its higher payments to the maquiladora. The deductions of the increased payments will generally have the effect of reducing the U.S. tax liability of profitable U.S. companies in an amount that is roughly equal to the increase in the Mexican tax liability of the Mexican companies that result from those increased payments.

There will be some increase in the income tax burden for most U.S. companies as a result of opting to operate under the new rules. This is because many U.S. companies will not be able to obtain a full foreign tax credit for the total amount of the 35 percent Mexican income tax being imposed on the increased taxable income of the Mexican companies and the 5 percent Mexican withholding tax that will apply to the maquiladoras’ increased distributions of their additional after-tax profits back to their U.S. parent companies as dividends.

In addition there could be a substantial increase in the overall income tax burden of a U.S. company that is in a loss position or a U.S. company that is unable to obtain foreign tax credits for the increased Mexican income tax. It is important that the governments give further consideration to these issues.

Apart from the question of double taxation, the intergovernmental agreement has also addressed the other major problem that industry groups and many companies have identified — that Mexico’s initiative to tax the U.S. companies would have plunged the industry into turmoil because of the total lack of standards for determining the portion of the U.S. companies’ income that Mexico would have taxed as being attributable to a permanent establishment in Mexico. The agreement seeks to reduce uncertainty and the potential for controversy in four ways, all of which have been discussed above: (1) it puts the tax burden back on the Mexican company so that it will be dealt with under transfer pricing principles, (2) it provides standards for determining how Mexico can change its transfer pricing rules to generate more taxable income for the Mexican company, (3) it contains the specific agreement of the United States to consider the amount of tax revenue that Mexico could have generated from the U.S. companies in defining the long-term standards that Mexico can use to increase the taxable income of the Mexican companies, and (4) it establishes a unique process of consultation between the two governments to develop the specific standards that Mexico should apply in taxing these Mexican companies.

One issue that the agreement does not address is the increase that maquiladoras will generally experience in their mandatory profit-sharing liability as a result of the new tax regime for maquiladoras. To the extent that the Mexican companies are already paying income tax and profit sharing based on arms-length prices, then it may be artificial to
increase the maquiladora’s mandatory profit sharing payments as result of an increase in its taxable income by amounts that would not have been subject to mandatory profit sharing if Mexico had taxed the U.S. companies on those same amounts. This extra mandatory profit sharing is an extra cost because it is not an income tax that would be eligible for a U.S. foreign tax credit.

At a minimum, Mexico should address the tax problem created by the extra mandatory profit-sharing payment, which arises because payments of mandatory profit sharing are -generally not deductible for Mexican income tax purposes. It would be helpful for Mexico to amend its law to allow a deduction for mandatory profit sharing, or at least for the extra mandatory profit sharing caused by adopting one of the alternatives set forth in the intergovernmental agreement, and to remove the extra mandatory profit-sharing payments from both the operating expense deductions used as the base for the second prong of the new safe harbor threshold, as well as from consideration as a cost in any transfer pricing methodology that is based on the maquiladora’s operating costs.

Options for Structuring Maquiladora Operations

The intergovernmental agreement has created additional alternatives for companies to consider in structuring their maquiladora operations and avoiding unacceptable tax risks. Each U.S. company will need to consider both the new choices that their maquiladoras have available to them under that agreement and the other alternatives that are still available to them under generally applicable law and treaty provisions.

For some companies those other alternatives may be preferable to the choices offered by the intergovernmental agreement, depending in part on the details of the transfer pricing methodologies that Mexico implements in APAs issued under the agreement. Those other alternatives should generally allow the Mexican company to be subject to Mexico’s normal transfer pricing rules, based on OECD principles, rather than the new safe harbor rules or the new transfer pricing rules being developed under the intergovernmental agreement. In principle, Mexico should continue to issue Mexican transfer pricing rulings based on the OECD rules to maquiladoras that do not choose to operate under the new rules, and in many cases companies choosing these alternatives may not feel the need to obtain a transfer pricing ruling.

In addition any company that is structuring manufacturing operations in Mexico will need to give greater attention to the implications for their mandatory profit-sharing liability of each structuring alternative that is available to them.

Implications for Non-U.S. Companies

The agreement between the United States and Mexico applies only to U.S. companies and their manufacturing contracts with Mexican maquiladoras. In principle Mexico should not need such intergovernmental agreements with other jurisdictions because only the permanent establishment provisions of the Mexico-U.S. tax treaty contains the special language that Mexico was relying on in its initiative to impose its income tax on the U.S. companies. For that reason, Mexico’s repeal of the Transitorio that has protected U.S. companies from this special permanent establishment rule under the Mexico-U.S. tax treaty has in principle had no effect on companies from other countries with which Mexico has an income tax treaty.

It will be important, however, for Mexico to confirm that it will continue to apply normal transfer pricing principles, as it has done in the past, in issuing transfer pricing rulings to maquiladoras with respect to their contracts with countries in those jurisdictions and that those foreign companies will continue to be exempt from Mexico’s asset tax if their maquiladoras receive Mexican transfer pricing rulings based on normal OECD principles.

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.