Global Tax Alert (News from Americas Tax Center) | 11 September 2013

Mexico's tax reform proposal significantly affects maquiladora industry

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On 8 September 2013, Mexico’s President Pena Nieto presented a major tax reform proposal (the Proposed Reform) to the Mexican Congress that significantly affects the maquiladora industry. The proposal must be debated and approved by the two houses of Congress by the end of October before becoming law (with an expected effective date of 1 January 2014).1

As part of the modifications, the proposal includes significant changes to the maquiladora industry, including a new definition of what qualifies as maquiladora activities for income tax purposes and eliminates exemptions to the once beneficial value added tax treatment.

Based on the preamble to the Proposed Reform, these proposed modifications are necessary: (1) to restrict the application of the tax benefits to the originally intended beneficiaries, (2) to avoid inequalities and disadvantages with respect to the Mexican domestic industry, and (3) to provide additional control and oversight mechanisms to the tax authorities with respect to the application of the tax benefits. Likewise, the preamble indicates that the elimination of a preferential tax regime is consistent with the OECD’s recommendations.

Finally, the Proposed Reform states that the economic considerations that justified the creation of the maquiladora regime are no longer present. Thus, these modifications attempt to return to the requirements that motivated the original design of the maquiladora regime (such as the exportation of all of its production). Moreover, this proposal would also allow for differentiating companies that benefit from the income tax benefits of this regime from those that only apply the customs benefits.

The following section summarizes the main proposed modifications.

Income tax

Permanent establishment

Currently, the Mexican Income Tax Law (MITL) provides that foreign residents are entitled to a statutorily provided exemption from creating a permanent establishment (PE) in Mexico as a result of their economic or legal ties to maquiladoras, provided that the foreign parties are resident in a country with which Mexico has entered into a Tax Treaty and the maquiladora meets the transfer pricing guidelines provided in the MITL.

It bears noting that this exemption is provided for those activities qualifying as “maquiladora activities.” The definition of “maquiladora activities” under Article 33 of the IMMEX (Mexico’s maquiladora program) Decree was modified, effective 1 January 2011. This definition provides that, among others, at least 30% of the machinery and equipment used in the maquiladora operations should be owned by the foreign resident principal.

The proposed reform incorporates a new definition of “maquiladora activities” in Article 175 of the new MITL. This new definition of “maquiladora activities” is very similar to the definition introduced under the modification to Article 33 of the IMMEX Decree. However, several important differences should be noted:

  • Section I provides that the goods must be returned abroad without referencing the ability to use virtual exports to meet this requirement. Notably, Article 33 of the IMMEX Decree explicitly allows virtual exports in meeting the requirement of returning abroad a transformed good.
  • Section II of the definition under Article 175 adds an export threshold of 90% of the Maquiladora’s total annual invoicing. Notably, it does not clarify whether the export threshold could be met with virtual exports and/or indirect exports.
  • Section IV provides that machinery and equipment must be owned by the foreign resident. However, unlike Article 33 of the IMMEX Decree, no reference is made to whether the maquiladora company may also own machinery and equipment.
  • Likewise, Section IV of this new definition does not include the 30% minimum threshold for machinery and equipment owned by the foreign resident nor the “grandfathering” provisions to companies performing maquiladora operations through 12-31-2009, which are currently provided under Article 33 of the IMMEX Decree.
  • Finally, product development and quality improvement operations no longer qualify as maquiladora activities for purposes of applying the tax benefits.

Moreover, the PE exemption for shelter maquiladoras is limited to three years. After such period, the

foreign resident will be exposed to PE status in Mexico or will need to establish its manufacturing activities through its own subsidiary.

Without the PE exemption, the determination of whether a PE exists should be made based on the facts and circumstances of the operations of the foreign resident in Mexico, under Mexican tax rules, as well as the applicable tax treaty.

With elimination of the IETU2 law, the 2007 Calderon Presidential Decree that expires on 31 December 2013 will not be renewed. Consequently, maquiladoras will no longer be eligible for a reduced effective tax rate of 17.5%. Maquiladoras would be subject to the normal corporate income tax rate of 30%. Likewise, considering that the 2003 Fox Presidential Decree references the old income tax law, the tax credit offered by the Fox Presidential Decree is presumably also eliminated.

Transfer pricing

Currently, Article 216-Bis of the MITL provides specific transfer pricing methodologies for companies operating under the maquiladora program. These transfer pricing methods may create a simplified transfer pricing compliance mechanism and may provide an ability to reach a more favorable transfer pricing result vis-à-vis Mexico’s transfer pricing guidelines for non-maquiladora companies.

The existing available methods include:

  • Transfer pricing study based on cost plus mark-up +1% of value of foreign owned M&E – This method consists of determining an arm’s-length cost plus mark-up and adding a value equal to 1% of the net book value of the foreign-owned, fixed assets.
  • Safe Harbor – This method provides that the taxable income of the maquiladora should represent the greater of a 6.9% return on assets (ROA) calculation, including the value of foreign-owned fixed assets and inventory or a 6.5% mark-up on costs. In determining the cost base, all operating costs related to the maquiladora operation, including costs borne by the foreign related party, should be considered, except for a) inventory purchases made by the foreign related party, b) depreciation on foreign owned assets, c) costs borne by a foreign related party outside of Mexico, d) financial costs (e.g., interest and foreign exchange losses), and e) B-10 inflationary adjustments.
  • Transfer pricing study based on ROA methodology – This method consists of preparing a transfer pricing study in accordance with the transactional net margin method and applying an ROA profit level indicator. The ROA calculation must include foreign owned fixed assets (but excludes inventory).

Additionally, the maquiladora may elect to file for an advanced pricing agreement (APA) if it wishes to obtain certainty regarding its transfer pricing policies.

The Proposed Reform modifies the transfer pricing methods available for the maquiladoras to eliminate the transfer pricing alternatives. Thus, maquiladoras may only apply the Safe Harbor methodology or pursue an APA. The new rules under the Proposed Reform resemble the transfer pricing rules available to maquiladoras prior to 2002.

Value Added Tax (VAT)

Under existing rules, maquiladoras are entitled to several benefits regarding VAT, including:

  • No import VAT as a result of conducting a temporary importation.
  • A 0% VAT rate applies on the maquiladora services fee invoiced to its related party (related to export production).
  • Certain sales of goods that are physically located in Mexico and imported temporarily are exempt from VAT. This exemption includes sales between non-Mexican companies, as well as certain sales between non-Mexican companies and maquiladoras.
  • When a maquiladora purchases goods or services from certain Mexican suppliers, it has the option to withhold the applicable VAT on the purchase. Thus, the maquiladora is entitled to an immediate credit of the VAT, resulting in no net cash outflow related to the VAT.
  • A non-Mexican company may purchase goods from certain Mexican suppliers with a 0% VAT rate as long as the goods are physically delivered to the maquiladora’s facility and the proper virtual pedimento (customs-related) filings are made.
  • The maquiladora company may withhold VAT on purchases made to Mexican suppliers. This withholding mechanism minimizes cash flow implications for the maquiladora.

The proposed reform eliminates some of these beneficial VAT rules, as follows:

  • Temporary importations will now be subject to VAT at the general rate of 16% (including those made in the border region and through virtual pedimentos) with allowed credit or refund once the goods are returned abroad. That is, temporary importations are no longer exempt from VAT and the recovery of the VAT paid may take significant time and effort. Companies must carefully evaluate the cash flow implications arising from this proposal.
  • The VAT exemption on sales of temporarily imported products between non-Mexican parties or from non-Mexican residents to maquiladoras is eliminated. Such sales may be subject to VAT also at the rate of 16%, which will only be recoverable if the purchaser is a VAT taxpayer in Mexico, otherwise the VAT will become an additional cost.
  • It is worth mentioning that these two proposals will directly affect supply chain structures, as each virtual importation made along the chain will be subject to VAT and each sale made by non-Mexican residents in connection with such transfers will also be subject to VAT because the goods are being sold within Mexico.
  • Finally, the option to withhold VAT on purchases of goods or services from certain Mexican suppliers is eliminated.

In summary, if the proposed changes are approved by Congress, companies currently benefitting from the maquiladora regime will have to carefully evaluate the effect that the proposed reform would have on their existing operations.

Endnotes

1. See EY Global Tax Alert, Mexico’s President presents tax reform proposal to Congress, dated 9 September 2013, for further information on the full tax reform proposal.

2. IETU (Impuesto Empresarial a Tasa Unica) is generally referred to as Mexico’s “Flat Rate Business Tax.”

For additional information with respect to this Alert, please contact the following:

Mancera, S.C., International Tax Services, Mexico City
  • Manuel Solano
    +52 55 11 01 6437
    manuel.solano@mx.ey.com
  • Koen van´t Hek
    +52 55 11 01 6439
    koen.van-t-hek@mx.ey.com
Mancera, S.C., Latin American Business Center, Mexico City
  • Terri Grosselin
    +52 55 11 01 6469
    terri.grosselin@ey.com
Ernst & Young LLP, Latin American Business Center, New York
  • Alfredo Alvarez
    +1 212 773 5936
    alfredo.alvarez@ey.com
  • Alejandra Sanchez de la Garza
    +1 212 773 7634
    alejandra.sanchezdelagarza@ey.com
Ernst & Young LLP, Latin American Business Center, Dallas
  • Michael Becka
    +1 214 969 8911
    michael.becka@ey.com
Ernst & Young LLP, Latin American Business Center, San Diego
  • Ernesto Ocampo
    +1 858 535 7383
    ernesto.ocampo@ey.com

EYG no. CM3796