Mexico and the United States reach agreement on maquiladora taxation

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

Reprinted with permission from Tax Notes International, Nov. 8, 1999

Mexico and the United States Oct. 29 announced 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 Jan. 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 Oct. 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 manufacturing 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 ground 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 the 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 establishment 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 withholding 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 some 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 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 Jan. 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.

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 US. 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 comapnies 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.

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 US. 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 govemments 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 the 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 arm's-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 and from consideration as a cost in any transfer pricing methodology that is based on the maquiladora's operating costs.

The intergovernmental agreement has added 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 its maquiladoras have available to them under that agreement and the other alternative 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 that alternative 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.

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, AC (CNIME) and to the Maquiladora IPITEX 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 has been edited to fit The Chamber News.