On September 8, 2013 Mexico's President, Enrique Peña Nieto, submitted to the House of Representatives of the Mexican Congress a bill proposing an extensive reform of Mexico's tax system (Tax Reform). Please note that the proposed bill submitted by the President of Mexico is pending the corresponding analysis and debate at the House of Representatives and at the Mexican Senate, in which case, several of the proposed provisions may be modified. However, due to the importance of the proposed Tax Reform, we provide this bulletin to highlight the main aspects that may affect the operations of maquiladora companies.
The purpose of this bulletin is to provide an industry focused discussion of the changes proposed in the Tax Reform that would have an impact on companies known as Maquiladoras or "IMMEX Companies" because they operate under a program authorized pursuant to the Decree for the Promotion of the Manufacturing, Maquiladora and Export Services Industry (IMMEX Decree, for its acronym in Spanish).
A number of the most important and troublesome proposals in the Tax Reform would amend provisions of the VAT Law and Income Tax Law that apply specifically to Maquiladora operations. If enacted without modifications, those changes would substantially increase the costs and uncertainty of manufacturing in Mexico and would disrupt the supply chains that are important to Mexico's manufacturing sector. This may call into question Mexico’s compliance with the Mutual Agreement on Maquiladora Taxation between the United States and Mexico.
The proposed changes to the application of the VAT Law and the Income Tax Law to Maquiladora operations also contain several provisions that create uncertainties and may lead to unintended consequences, due to the actual drafting and its possible effects for the Maquiladora transactions to which they would apply. We have also highlighted these as issues that companies operating in the Maquiladora industry must consider and that the Congress will need to address in the legislative process.
- General Provisions of the Proposed Tax Reform
The Tax Reform includes a proposal to repeal Mexico's Single Rate Tax (IETU). This is important for Maquiladoras because it would eliminate the need for extension beyond the end of 2013 of the Presidential decree issued in 2007 that has protected Maquiladoras from a large increase in their total Mexican tax liability under the IETU.
The President has also proposed that the Congress enact a new Income Tax Law to replace the existing Income Tax Law as of January 1, 2014. The proposed Tax Reform includes a number of generally applicable changes in the Value Added Tax Law (VAT Law), the Special Production Services Tax Law (IEPS, for its acronym in Spanish) and the Federal Tax Code. While those changes would affect all companies including Maquiladoras, discussion of most of those changes is beyond the scope of this bulletin.
- Income Tax Law Changes for Maquiladoras
The proposed changes in the Income Tax Law would increase the overall tax burden and administrative costs of manufacturing products for export in Mexico and may eliminate the permanent establishment exemption for foreign companies whose Maquiladoras deliver products in the supply chains of the automotive industry and other industries in Mexico. This may give rise to other new uncertainties for Maquiladoras and their foreign principals, unless they are modified in the legislative process. This is in part due to generally applicable changes in the law and to the new provisions defining the income tax treatment of a Maquiladora operation.
Companies need to evaluate how their Maquiladora operations would be affected by the proposed changes, the most important of which would:
- Introduce provisions redefining what constitutes a Maquiladora for tax purposes, which may be interpreted to limit the category of Maquiladoras that can benefit from the special rules for Maquiladoras in the income tax law, and which if not changed or clarified in the legislative process may eliminate the existing permanent establishment exemption for an important part of the Maquiladora industry,
- Increase the tax and administrative costs for many Maquiladoras in qualifying for those benefits by eliminating the alternative of determining the amount that the Maquiladora needs to receive from its foreign principal for its processing services with a transfer pricing study without the need to obtain an APA.
- Increase the tax burden on Maquiladora operations due to the operation of generally applicable limitations on deductions proposed in the Tax Reform that would have a disproportionate impact on Maquiladoras.
A. Special Tax Rules for Maquiladoras Under the Income Tax Law
Nonresident entities are subject to Mexican income tax only on income that is attributable to a permanent establishment of the nonresident company in Mexico and on certain categories of payments that are treated as Mexican source income. In general terms and among other scenarios, a permanent establishment exposure can be created when a nonresident entity has an arrangement with a Mexican party that processes inventories consigned by the nonresident using assets also furnished by the nonresident. This describes the consignment manufacturing arrangements that most companies have implemented for their Maquiladora operations.
Mexico has recognized that having a permanent establishment in Mexico is generally unacceptable to a foreign company because of the high likelihood that the resulting imposition of Mexican tax on a portion of the foreign company's net income would result in double taxation. Companies would be less likely to operate in Mexico if that resulted in any significant risk that the country would attempt to tax the foreign company on the grounds that it has a permanent establishment, or if in order to avoid a permanent establishment exposure, the company was required to structure its operations in Mexico in a manner that was not optimal from a global perspective. Because companies find it most convenient from a business perspective to structure export manufacturing operations using consignment manufacturing arrangements with the local company in the manner described above, it is essential that Mexico provide an adequate permanent establishment exemption for foreign companies that wish to structure their export manufacturing in Mexico in this way with a Maquiladora.
Therefore, since 2002 Mexico has included in the Income Tax Law an exemption from such permanent establishment exposure for those nonresident entities that enter into a consignment manufacturing arrangement with a Mexican legal entity that conducts a "maquila operation" (as discussed further below). The law requires that, in order to be eligible for the permanent establishment exemption, the foreign entity must be a tax resident of a country with which Mexico has a treaty for the avoidance of double taxation (Tax Treaty), and the requirements of the respective Tax Treaty must be complied with, including when applicable the mutual agreements issued in accordance with the respective Tax Treaty.
Through a Presidential decree issued in 2003, Mexico has also granted relief in calculating the rate of income tax to be imposed on the tax base of a Maquiladora that has satisfied the requirements for obtaining a permanent establishment exemption for its foreign principal.
B. New Narrower Definition of Maquila Operations for Income Tax Purposes
The proposed Tax Reform would narrow the circumstances in which a foreign company could obtain protection from permanent establishment exposure, by including in the Income Tax Law a definition of what constitutes a "maquila operation" for tax purposes. The proposed introduction of that definition into the Income Tax Law is designed to exclude some Maquiladoras from the application of this and other tax benefits previously available to all Maquiladora operations under the Income Tax Law.
According to the proposed bill to reform the Income Tax Law, in order for a nonresident to avoid a permanent establishment exposure stemming from the legal or economic relationship it has with a Maquiladora, it would need to satisfy the following conditions, which are similar to those that Mexico imposed through its 2010 amendments to the Article 33 of the IMMEX Decree:
- The raw materials and components used by the Maquiladora in its manufacturing activity would be required to include materials or components that are consigned by the nonresident to the Maquiladora and imported on a temporary basis.
- All of the products manufactured in the Maquiladora would need to be physically exported.
Whether or not this provision is interpreted as requiring that the Maquiladora itself must physically export all of its production, it would eliminate the permanent establishment exemption for the foreign principals of virtually all Maquiladoras involved in supply chains in Mexico. This change, intended or not, would result from the failure of the proposed requirements of Article 175 of the new Income Tax Law that referred to transfers to other Maquiladoras or OEMs using virtual pedimentos as a way for a Maquiladora to satisfy the export requirement for this purpose. In order to avoid disruption of Mexico's export industry, which depends on production through supply chains involving suppliers and OEMs, this problem should be corrected by restoring to the proposed provision language that is in a similar provision of the IMMEX Decree to provide that this requirement will also be satisfied by the deemed export of products manufactured by the Maquiladora using virtual pedimentos.
A similar action by Mexico in 1998, repealing the permanent establishment exemption for foreign companies participating in the Maquiladora industry, proved unacceptable and led to negotiations between the United States and Mexico that resulted in reinstatement of the permanent establishment exemption for Maquiladora operations under the terms of the Mutual Agreement on Maquiladora Taxation between both countries, which is still in effect. It is doubtful that Mexico has intended to create such an issue again, or to call into question whether it has violated the terms of the Mutual Agreement with the United States by effectively having eliminated the permanent establishment exemption for the Maquiladoras covered by the Agreement that constitute the most relevant parts of the Maquiladora industry. Nevertheless, that appears to be the effect of the proposal, to deny the permanent establishment exemption to the Maquiladoras that participate in export supply chains in Mexico by attempting to redefine what will be treated as an "operación de maquila" solely for Mexican tax purposes.
- If domestic or permanently imported inputs are utilized in the manufacturing process, such inputs would need to be exported along the finished products.
- The Maquiladora would be required to subject the raw materials and components to a "transformation" or repair activity for their subsequent return or exportation. Among other things, this provision is designed to deny the benefit of the permanent establishment exemption and other special Maquiladora tax rules for purposes of the Mexican income tax to Maquiladoras that conduct their operations under a service maquiladora program.
The proposed provision establishes that the following activities qualify as "transformation" for this purpose:
- Dilution in water or other substances.
- Washing or cleaning, including the removal of oxide, grease, paint or other coatings.
- The application of conservatives, including lubricants, protective encapsulation or painting for conservation
- Adjustment, sanding or cutting.
- Preparation in doses.
- Packing and repacking.
- Testing, marking, labeling or classification.
That should not be read as an exclusive list because manufacturing activities (i.e. assembly or the substantial transformation of one good into another with added value) also constitute transformation. The Congress should, however, clarify the provision to make it clear that manufacturing constitutes transformation and that the listed items are only examples of what constitutes transformation for the purpose of this rule.
- The Maquiladora would be required to export at least 90% of its total annual invoicing.
This is a new requirement for Maquiladoras (not previously established in Article 33 of the IMMEX Decree) under which Maquiladoras now would only be able to invoice domestically up to 10% of their total annual invoicing. In this respect, it should be pointed out that the proposed requirement refers to amounts invoiced by the Maquiladora, including its invoices for its processing services, which should qualify as an export invoice because they are invoices for an export of services. The requirement does not refer to exportation of goods manufactured by the Maquiladora unless it issues invoices for the sale of those goods.
Thus the provision should not be read as regulating the portion of the products manufactured by the Maquiladora that must be physically exported from Mexico because that is not what it says. Moreover, as noted above, eliminating the ability for a Maquiladora to satisfy the export requirement with a customs transfer to another Maquiladora or an OEM using virtual pedimentos would throw the already existent productive or supply chain of the Maquiladora industry into turmoil because of an unfeasibility to treat the transferred goods as returned abroad/exported, which in turn would constitute effectively a repeal of the permanent establishment exemption for consignment manufacturing operations. As noted above, such a provision would call into question whether Mexico has violated the terms of the Mutual Agreement with the United States by effectively having eliminated the permanent establishment exemption for the Maquiladoras covered by that Agreement that constitute the most relevant part of the Maquiladora industry.
One unintended consequence of the proposed provision would be to create potential permanent establishment exposure and loss of other Maquiladora tax benefits for any Maquiladora that, in addition to conducting a Maquiladora operation, also has other non-maquiladora operations that are segregated from their maquila operations, and which are subject to regular taxation in Mexico, without any special treatment. That is allowed under Mexican law, and presumably it was not the intention of the government to deny the application of the tax rules for a maquila operation arbitrarily to companies that conduct such operations in compliance with the law. Thus, that is another provision that needs to be corrected in the legislative process.
In the event that the proposed bill to reform the Income Tax Law is approved without change, however, companies should carefully consider whether it would be prudent to limit invoicing of non-maquila operations from a Maquiladora in order to prevent its annual domestic invoicing from exceeding 10% of its total annual invoicing. For example, the 90% threshold may be exceeded in the event that the Maquiladora sells property or goods as in extraordinary or non-maquila transaction in Mexico, when such transactions represent more than 10% of the total annual invoicing.
- The transformation or repair process would need to be undertaken with machinery and equipment belonging to the nonresident that has not been owned by the Maquiladora that will undertake the manufacturing operations or by a related party resident of Mexico.
This provision does not state the amount of foreign owned machinery and equipment that must satisfy those requirements. In that respect it differs from the similar provision in the existing Article 33 of the IMMEX Decree, which provides that at least 30% of the machinery and equipment shall be property of the foreign principal of the Maquiladora that had never been owned by the Maquiladora or a related Mexican party. The provision that the Government has proposed does not appear to have created a requirement that all machinery and equipment used in a Maquiladora operation must be owned by the foreign principal, a requirement that again would effectively repeal the permanent establishment exemption for consignment manufacturing for a large portion of the Maquiladora industry.
On the other hand, the provision of the bill regarding machinery and equipment does not contain the "grandfather" provision such as that which is included in the IMMEX Decree to exempt from such requirements those companies that secured their authorization of their Maquiladora Programs prior to December 31, 2009, and that were complying with one of the three alternatives for satisfying their transfer pricing obligations under the terms of Article 216-Bis of the Income Tax Law. This lack of a grandfather clause in the Income Tax Law for such operations could have the effect of adversely affecting companies whose longstanding Maquiladora operations do not satisfy the requirements of the proposed rule. In such cases, the absence of a grandfather provision for companies that were previously protected from the application of similar requirements under the IMMEX Decree may be subject to challenge from a constitutional standpoint on the ground that it would deprive the Maquiladora of a vested right in a retroactive manner (giving the new provision a retroactive effect to matters that took place in the past).
It will be important for taxpayers to determine whether the inclusion of this separate definition of a "maquila operation" for tax purposes in the Income Tax Law would result in the repeal of the definition of "maquila operation" for tax purposes in the IMMEX Decree as of the end of 2013, under the terms of the transitory articles of the Income Tax Law that have been proposed in the Tax Reform. If that was not the case, then Maquiladoras would need to consider whether they would be required to satisfy the requirements of both the law and the IMMEX Decree in order to qualify for the permanent establishment exemption and other maquiladora tax benefits in cases in which the IMMEX Decree imposes conditions more restrictive than those set forth in the law.
In any event companies should also consider the implications of a recent decision of the Supreme Judicial Court of Mexico, which declared invalid the restrictions imposed by the IMMEX Decree on the ability of a service maquiladora to obtain the benefits of the maquiladora tax regime, on the grounds that a decree cannot validly deprive a taxpayer of benefits granted by the law. (Amparo en revisón 609/2012, issued by the Second Chamber of the Mexican Supreme Court of Justice).
C. Payments That a Maquiladora Must Receive for its Processing Services
The proposed tax reform would change the requirements that a qualifying Maquiladora must meet with respect to the payments that it receives for its processing services in order for the foreign principal to obtain a permanent establishment exemption. The proposed change would substantially increase the Mexican tax costs, or the administrative costs, or both, for Maquiladora operations that have relied on a transfer pricing study to meet these requirements for 2013 and prior years.
Under the proposed law, the Maquiladora and its foreign principal would be required to satisfy one of the following two alternatives each year with regard to the amount that the foreign company pays the Maquiladora for its processing services:
The first alternative that a Maquiladora could choose on an annual basis would be for the payments of the foreign company to the Maquiladora to be sufficient to enable the Maquiladora to generate taxable income of not less than a "safe harbor" amount, calculated in much the same manner as under current law, equal to the greater of the following:
- 6.9% of the total value of assets used in the maquila operation during the tax year, including those owned by the Maquiladora, by nonresidents, or by any related parties thereof, even where granted to the maquiladora.
- 6.5% of the total amount of costs and operating expenses for the operations in question, incurred by the resident and determined pursuant to the norms of financial information (consistent with the generally accepted accounting principles of Mexico).
Advance Pricing Agreement (APA)
The second alternative that a Maquiladora could choose on an annual basis under the proposed law would be to obtain an APA from the Mexican tax authorities. It is unclear whether the proposed provision creating this alternative of getting an APA as a basis for obtaining the permanent establishment exemption preserves the ability of the Mexican tax authorities, expressly granted in existing law, to require that the Maquiladora take into account the profitability generated for the foreign principal by the machinery and equipment owned by the principal and used in the maquila operation in determining the profitability that the Maquiladora must achieve under the APA, given that taking foreign owned machinery and equipment into account in this way would not be consistent with normal transfer pricing rules under Mexican law.
The proposed limitation to these two alternatives for determining the required payments from the foreign principal to the Maquiladora would be a change from current law in that it would eliminate the alternative that has been in Article 216 Bis of the Income Tax Law for more than 10 years, for a Maquiladora to obtain the permanent establishment exemption and other tax benefits for a tax year by obtaining transfer pricing study for the year evidencing that the amount of its income in payment for its processing services is equal to the sum of:
- An amount equal to a price for the services determined under the arm’s length principles set forth in the Income Tax Law, in concordance with the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, approved by the Council of the Organization for Economic Cooperation and Development in 1995, or any rules that replace them.
- An amount equal to 1% of the net book value of the foreign-owned machinery and equipment, on the books of the foreign party owning the machinery and equipment, the use of which is granted free of charge to the Maquiladora for use in its manufacturing operations during the year in question.
Maquiladoras constituting a majority of the industry in Mexico have chosen to rely on the alternative of getting a transfer pricing study on that basis, instead of obtaining an APA or meeting the requirements of the Safe Harbor. The alternative provides a level of certainty comparable to electing to meet the requirements of the Safe Harbor and avoid costs and inherent uncertainties of seeking an APA from the Mexican Tax Authorities.
The proposed change in the law in this regard would be a step backwards that would return Mexico to the state of affairs that prevailed prior to 2003, when many Maquiladoras, which did not want to meet the requirements of the Safe Harbor, were forced to seek either a unilateral APA from the Mexican tax authorities or a bilateral APA between the United States and Mexico. In order to avoid this, Mexico introduced the alternative that the government is now proposing to repeal.
The Congress urgently needs to consider preserving the alternative of using a transfer pricing study, without the need for an APA, to obtain the necessary permanent establishment exemption for a foreign company dealing with a maquiladora operation, as currently set forth in Article 216-Bis of the Income Tax Law, perhaps modestly increasing the additional amount to be included in the transfer price.
Otherwise, companies may be limited to choose between using the Safe Harbor, which in most cases may increase either their Mexican income tax liability or their overall global income tax liability, or incurring the administrative costs and uncertainties inherent of obtaining a unilateral or bilateral APA. This change would constitute an unnecessary drag on Mexico's ability to attract companies to conduct Maquiladora operations in Mexico; especially capital intensive companies in industries such as Automotive and Aerospace, which Mexico has targeted for expansion in order to strengthen its economy.
Moreover, capital intensive Maquiladoras whose foreign principals are outside the United States could be forced to obtain APAs, and in many cases bilateral APAs, because only the United States has agreed with Mexico (in the mutual agreement on Maquiladora taxation entered into on 1999) to allow the foreign principal to deduct a payment to a Maquiladora in excess of a normal transfer price in order to enable the Maquiladora to meet the Safe Harbor threshold for its taxable income.
D. Substantial Tax Increase on Maquiladora Operations
The proposed changes in the Income Tax Law include generally applicable limitations on certain deductions, including new rules that (1) would deny 59% of a company's deductions for those elements of employee compensation that are exempt from tax for the employee for income tax purposes and (2) would deny a company's deductions for payments that it makes to cover the employee portion of Social Security contributions.
These particular limitations on deductions would result in a substantial tax increase for Maquiladoras because a significant portion of their costs and expenses correspond precisely to those payments deemed tax exempt income for the employee.
Preliminary calculations undertaken by companies since the Tax Reform was proposed suggest that the denial of these deductions would most likely have the effect of possibly doubling or tripling the taxable income of most industrial maquiladoras, which would result in a similar or much greater increase in their overall tax liability, depending on several factors including: how Mexico handles the question of the income tax rate that will apply to Maquiladora operations, whether Congress adopts the proposal to limit the Maquiladora's choices for determining its compensation to a choice between meeting the requirements of the Safe Harbor or obtaining an APA, and the limitations that would apply to the Maquiladora's foreign company on its ability to obtain an indirect foreign tax credit for large increases in Mexican tax payments by the Maquiladora.
A similar problem arose uniquely for Maquiladoras in 2007 in connection with the denial under the IETU law of deductions for the cost of employee benefits that are tax free to the employees, in determining the tax base for purposes of the IETU. At that time the Mexican government recognized the problem and, in order to deal with it, the President issued a decree, which has continued to govern the application of the IETU to Maquiladoras, that has allowed Maquiladoras, and only Maquiladoras, to use their income tax base to determine their income tax liability.
A similar creative solution will be required for Maquiladoras in order to avoid the possible damage to Mexico's manufacturing sector if Congress approves the proposed limitations on deductions for employee compensation and for payments to cover the employee portion of Social Security contributions. This would be especially important if the Government decides to abrogate the 2003 decree that provides for a reduced income tax rate for Maquiladoras or if it were determined that the provisions of the new Income Tax Law themselves had the effect of abrogating that Decree.
It is important to note that failure to address this problem would give rise to an issue of double taxation for some companies whose Maquiladoras experience a large percentage increase in their income tax liability in Mexico as a result of the proposed changes. For example, because the increase in Mexican tax liability would not be accompanied by a corresponding increase in the Maquiladora's earnings and profits for U.S. tax purposes, the result would be a large increase in the effective global tax rate for the Maquiladora operations and potential denial of a U.S. foreign tax credit for part of the Mexican tax liability.
E. Shelter Operations
In addition to the above, the proposed bill to reform the Income Tax Law provides a permanent establishment exemption for nonresident entities that operate in Mexico through a Maquiladora authorized under the modality of "shelter" and that enter into a processing agreement directly with the Maquiladora in Mexico. This protection would be limited to a transitional term of three years for each company, from the date it begins industrial operations in Mexico.
- VAT Law Changes for Maquiladoras
The changes that the Tax Reform proposes to make in the VAT Law would constitute a significant departure from the tax and trade policies that Mexico has implemented until now in order to avoid barriers to cross-border manufacturing operations in Mexico for export manufacturing. The cornerstones of those policies have been:
- A stable program for temporary importation of goods into Mexico for use by Maquiladoras without the imposition of VAT and without the imposition of duties in the case of the importation of materials and components.
- Carefully developed rules to eliminate the double imposition of VAT or the imposition of non recoverable VAT in the multitude of transactions that Maquiladoras must enter into with affiliates, suppliers and customers to insure efficient operation of the supply chains in industries such as automotive, aerospace, electronics and others.
These rules have reflected Mexico's understanding that company decisions on where to conduct export manufacturing operations are highly cost sensitive, and that squeezing transaction costs out of Maquiladora operations can provide a material benefit for companies and for Mexico's competitive position in the global economy, at a low cost for Mexico. Companies, in turn, have structured their supply chains in Mexico relying on the stability of the rules governing the tax consequences of their transactions. Because manufacturing operations are very cost sensitive, changes in the rules that have the effect of increasing transaction costs can be a significant issue for those operations, and the imposition of non-recoverable VAT in a significant number of Maquiladora transactions could make it uneconomical to conduct such operations in Mexico.
The proposed legislation would radically change the treatment of Maquiladora operations under the VAT law by:
- Imposing importation VAT on temporary importation of materials, components, machinery, equipment or products at the time of their importation, or deemed importation using virtual pedimentos.
- Delaying the time for refund of the resulting excess VAT payments to the time that the temporarily imported items are exported from Mexico.
- Repealing VAT rules for Maquiladora transactions that have been designed to avoid the double imposition of VAT or the imposition of non creditable VAT payments on transactions in the supply chain.
As in the case of the Income Tax Law, these proposed changes in VAT law would take effect on January 1, 2014.
A. Imposition of VAT on Temporary Importation
In its explanation of the proposed changes in the VAT Law, the Government explains that its reason for proposing the changes is to achieve better control of the ultimate payment of VAT, which it says has been degraded by changes over the years in how Maquiladoras are permitted to operate. This statement of purpose is an important standard against which to measure the actual effects of the proposed changes in the VAT Law, some of which would have potential outcomes that the government may not have fully considered.
Specifically, the proposed bill to reform the VAT Law would impose importation VAT at the rate of 16% on a base equal to the customs value of the goods in question in all temporary imports and customs transfers of materials, components, machinery, equipment, and products by Maquiladoras (as well as by bonded warehouses, tax precincts and strategic tax precincts) at the time of filing of the corresponding customs entry forms (pedimentos). Note that in connection with the rate of VAT that would apply to these transactions, the Tax Reform includes a proposal to extend the 16% VAT rate to the entire country and eliminate the lower 11% rate in the border area.
Because a Maquiladora's invoicing for its transactions typically consists of invoices to its foreign principal for processing services, which will continue to be zero rated for purposes of the VAT, a Maquiladora would not typically be able to recover the new importation VAT through the normal credit mechanism. The VAT Law provides for a refund of importation VAT that cannot be recovered as credit, in which case the imposition of importation VAT on temporary importation may represent primarily a financial cost and an administrative burden for many Maquiladoras. This financial cost and administrative burden is clearly something that Mexico is willing to impose on the Maquiladora industry in order to improve its control over the payment of VAT and to reduce the Government's costs. Nevertheless, the very large amount of additional importation VAT that will need to be paid, which must be recovered through a refund process, will raise concerns about the delays that may occur in getting the refunds and regarding the impact on the cost of the manufacturing operation of an inability to recover even a small portion of the large amounts of VAT that will need to be paid.
B. Timing of the Recovery of VAT Paid on Temporary Importation
Moreover, the Tax Reform proposal contains language that can be interpreted to impose a unique rule on Maquiladoras under which they would be required to wait to obtain a credit or refund of importation VAT imposed on temporary importation until the temporarily imported materials, components, machinery, equipment or finished products are exported from Mexico. This is in contrast to the normal rule under the VAT Law that a taxpayer can credit input VAT currently and seek a refund of any VAT that it cannot recover through a credit in the following month.
The proposed Tax Reform needs to be modified to make clear that the normal rules for recovery of VAT through a credit or refund will apply to the importation VAT that will now be imposed on temporary importation, and that the language about recovering VAT on exportation of the temporarily imported goods applies only in cases in which for some reason the VAT was not recovered on a current basis. Otherwise, that new rule will present several issues and potential problems:
- The Government does not explain why a Maquiladora's recovery of importation VAT on temporary importation should be delayed to the time of export of the goods. This rule does not create a level playing field for export manufacturing operations and other Mexican businesses, which the Government says in its explanation of the proposed changes that it is trying to achieve. Equity alone should require a modification of the proposal in the legislative process to allow Maquiladoras to credit and recover these new VAT payments immediately on the normal schedule applicable to other taxpayers.
- If Congress were to approve a provision delaying a Maquiladora's recovery of VAT paid on temporary importation to the time that the temporarily imported goods are exported, it would be essential, for purposes of this rule, that transfers accomplished through virtual pedimentos would be treated as exports in determining the right to credit or request the refund of the VAT imposed on temporary importation.
Maquiladora transfers of their finished products in the supply chain to parties in Mexico will continue to involve virtual exports and virtual imports, using virtual pedimentos. Such transfers are essential to the economical operation of the supply chains that companies have established in Mexico, which would be more expensive if companies were forced to bear the cost of physically exporting and reimporting products that contain temporarily imported materials or components for delivery to customers in the supply chain in Mexico. Imposition of importation VAT on those transactions will, in itself, place additional costs on manufacturing operations in Mexico. An inability to get a refund of that VAT upon the Maquiladora's virtual export of those goods at the time that it delivers the goods to another party in Mexico would be disruptive of the ability of manufacturers to operate in Mexico.
For example, it is common for a Maquiladora that manufactures vehicle parts to transfer them to an automotive OEM using virtual pedimentos. Even if it could be possible for the OEM to inform the Maquiladora if and when the OEM has physically exported the vehicle containing those parts, the indefinite delay in obtaining the VAT refund to which the Maquiladora is entitled would impose a significant unnecessary cost on its operations, which would interfere with Mexico's ability to maintain its competitive position as a location for export manufacturing.
Note that proposed provisions of the new Income Tax Law appear to require Maquiladoras to use temporarily imported materials or components that are provided by the foreign principal as a condition for obtaining the permanent establishment for the foreign principal. Therefore, it would not be feasible for a Maquiladora that operates under a consignment manufacturing arrangement to avoid those VAT issues by choosing to import definitively all of the foreign-owned materials and components required for its manufacturing activity. Moreover, some local offices of the Mexican tax administration have raised the question as to whether a Maquiladora is able to recover importation VAT that it pays on the definitive importation of materials and components owned by the foreign principal.
- The need for clarification that a Maquiladora can receive an immediate credit for importation VAT imposed on temporary importation is illustrated most forcefully in the case of temporarily imported machinery and equipment, which is not required to be exported from Mexico until it ceases to be used in the Maquiladora operation, which in many cases will not be for many years. Such indefinite delay in recovery of the very large amounts of VAT that would be imposed on the temporary importation of machinery and equipment would not be acceptable. Nor would it be a solution for Maquiladoras to definitively import the machinery and equipment that is owned by the foreign principal if there is risk either that this would result in a loss of the permanent establishment exemption for the foreign principal or that the Maquiladora would not be entitled to a credit for importation VAT imposed on definitive importation of foreign-owned machinery and equipment.
C. Repeal of VAT Exemption on Transfers of Temporarily Imported Items
Perhaps the most troublesome proposal for changing the VAT treatment of Maquiladora operations is the proposal to repeal Section IX of Article 9 of the VAT Law (Section IX of Article 9), which provides for an exemption from VAT for a foreign company's sales of temporarily imported materials, components, machinery, equipment or finished products to another foreign company, to the Maquiladora that has imported the goods on a temporary basis, or to other Maquiladoras. Under the proposed bill to reform the VAT Law, VAT would now apply to:
- A sale of temporarily imported goods from a nonresident to another nonresident (for example, a sale in the supply chain of products from the parent company of one Maquiladora to the parent company of another Maquiladora, with delivery to another Maquiladora or an OEM in Mexico, or the purchase of temporarily imported machinery and equipment by one foreign company from another in an acquisition of Maquiladora operations).
- A sale of temporarily imported goods from a nonresident to a Maquiladora (for example, a sale of machinery and equipment from the foreign principal under a Maquiladora processing agreement to the Maquiladora itself or to another subsidiary operating in Mexico as a Maquiladora).
These are common and necessary transactions for companies in the various industrial sectors in Mexico. For example, in the case of a Mexican company that operates in Mexico as a logistics and distribution center under a Service Maquiladora Program, they are becoming more common and more important as the chains of production and industrial clusters have been growing throughout the country. It is essential that the changes implemented in the VAT Law do not disrupt those transactions.
Foreign Party Sales of Temporarily Imported Goods to a Maquiladora
If VAT were imposed, the sale of temporarily imported goods from a foreign principal to its Maquiladora or to another industrial Maquiladora or service Maquiladora, as a result of repeal of Section IX of Article 9 of the VAT Law, then the Maquiladora would be required to "withhold" the applicable VAT, given that the foreign party is not registered as a VAT taxpayer in Mexico. This means that it would pay the full purchase price to the foreign principal and pay 16% of that amount to the Government as VAT on the transaction. In that case, it would be essential for it to be absolutely clear under the law that the Maquiladora is able to credit the VAT it has withheld and paid on those transactions. If the VAT imposed on those transactions as a result of the proposed repeal of Section IX of Article 9 of the VAT Law could not be recovered, that would constitute the imposition of non-recoverable VAT, which would impose a substantial extra cost to companies conducting a manufacturing operation in Mexico. It would also be contrary to the Government's position that the proposed changes in the VAT Law affecting Maquiladoras are for the purposes of improving control of VAT collections and not to impose additional non recoverable VAT burdens on Maquiladora operations.
Without further clarification in the VAT law, however, that would not be the case, one could conclude under the current provisions of the VAT Law that in order for VAT imposed on that transaction to be recoverable, the transaction must be documented with a tax invoice that complies with all the formal requirements of the Federal Tax Code. Because the nonresident would not be registered in Mexico for tax purposes and would therefore be unable to issue a tax invoice in compliance with the applicable Mexican tax requirements, it is not absolutely clear under the VAT Law that the Maquiladora would be able to credit the withheld VAT. It is not sufficient that this be covered by Miscellaneous rules that can be revoked at any time by the tax authorities.
Sales of Temporarily Imported Goods Between Foreign Parties
On the other hand, repeal of the VAT exemption for a foreign party's sale of temporarily imported goods to another foreign party would leave unanswered questions on how the resulting VAT would be imposed and collected and how it could be recovered if neither foreign party was registered as a VAT taxpayer in Mexico. These are difficult issues that would need to be addressed in any repeal of the application of Section IX of Article 9 to those transactions.
Because of the interaction between the VAT Law and the Customs Law, repeal of Section IX of Article 9 would also raise questions regarding the validity of these transactions under the Customs Law.
The Mexican Congress should reject the proposed repeal of Section IX of Article 9 unless (1) these issues can be clearly resolved in a way that would not be disruptive to the efficient conduct of the manufacturing supply chains in Mexico, and (2) the VAT Law is amended to clearly establish the ability of a Maquiladora to recover the VAT that it "withholds" and pays to the Government on purchases from a foreign party of temporarily imported materials, components, machinery, equipment or finished goods.
Meanwhile, companies need to review their Maquiladora operations to determine the extent to which their transactions in Mexico would be affected by this and other changes in the VAT Law that are included in the proposed Tax Reform.
D. Withholding of VAT on Sales to Maquiladoras by Domestic Suppliers
In addition to the above, the proposed bill to reform the VAT Law would eliminate the withholding obligation on sales of goods from domestic suppliers to a Maquiladora. As a result, the remaining choices under the law would be for domestic suppliers either to sell to the Maquiladora with VAT or to deliver the goods to the Maquiladora using virtual pedimentos.
This withholding option would result in an additional financial cost for many Maquiladoras that are currently applying this benefit and consequently recovering the VAT immediately.
- Amendments to the IEPS Law
The IEPS Law imposes an excise tax on importation of alcoholic beverages, tobacco, cigars, cigarettes, gasoline, diesel, additives to energizing beverages, flavored beverages, concentrates and other powder products to make beverages, syrup for preparation of beverages, natural gas, propane, butane gas, avgas, turbo sine and kerosene, mineral carbon, other fossil fuels. Some of these products are imported temporarily by Maquiladoras as inputs into their manufacturing process.
The Tax Reform includes an amendment to the IEPS Law that would require, as in the case of the proposed changes to the VAT Law, that IEPS tax has to be paid upon the temporary importation of goods whose importation is subject to such tax. In theory, the IEPS paid upon temporary importation would be recovered at the exportation of the goods.
- Amendments to the Federal Tax Code
One of the proposed amendments to the Federal Tax Code that is worth mentioning in light of recent public statements by the Mexican tax authorities is the proposed new anti-avoidance clause. Under the terms of that proposal, the Mexican tax authorities could recharacterize transactions for purposes of determining their tax consequences if they lack a business purpose. According to that proposal, it would be deemed that an operation or practice lacks a business purpose when it does not have an economic benefit quantifiable for the involved taxpayers, other than the avoidance, deferment or refund of the payments.
This grant of authority to the Mexican Tax Administration would of course be prospective to apply for transactions occurring in 2014 or later years, but it coincides with the authority that the Mexican Tax Administration may argue that it already can use as a tool in reexamining and challenging certain past transactions that involved a restructuring of Maquiladora operations. It is unclear whether many of those past restructurings would be subject to challenge under such a concept or under the authority that the Mexican Tax Administration already has to scrutinize transactions from past years, but taxpayers should be prepared for tax audits as statute of limitations periods come to a close for prior tax years.