Tax Reform and its Impact on Maquiladoras
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By Carlos Angulo, Congressman
The recent amendments made by Mexican Congress to the different tax laws will have a severe economic impact on maquiladoras. Since the mid-nineties there has been a powerful group of bureaucrats in Mexico, principally at Hacienda (Mexico's Treasury Department), that have been fighting the special rules that Mexico has established to nurture its maquiladora industry.
Maquiladoras spearheaded Mexico to become a major player in the export industry of the global economy. Many federal officials have considered maquiladoras as a cost to Mexico, alleging that they only contribute to create cheap jobs with a high cost of Mexican tax resources with the employment subsidy, generating very little income tax revenues and not adding value to the Mexican economy.
The purpose of this article is to explain in a clear way the impacts of the new tax reform which will be effective on January 1, 2014, and have a forth side on the different scenarios that may develop.
Let's start from the beginning, on how the maquiladora industry was conceived and what were the main features that were offered to investors to attract them to come to invest in Mexico.
During the early sixties, with the Bracero Program coming to an end, predictions of an overflow of people to the borders were the main concern of the Mexican Government. A group of entrepreneurs from the border cities, ordered a worldwide study from Arthur D. Little on what the Mexican border could offer in a newly developing global economy, and discovered that production sharing could be the answer.
As a result, the famous Twin Plant concept was born, where it was viewed as an opportunity of developing in both sides of the US/Mexico Border a business concept that in the US side a manufacturing company could be established where the capital intensive, and technological sensitive products could be made; and where in the Mexican side another plant could make the labor intensive, lower value added portion of the manufacturing process.
To achieve these objectives, the Maquiladora Program was conceived, where, initially a US company could open a branch on the Mexican side, and operate its branch as a simple "cost center", sending its raw materials and machinery and equipment under consignment in a duty free and tax free temporary importation environment, without starting a Mexican subsidiary company, with a corporate, financial and governance structure independent from its parent, where high capital investments were necessary.
So the idea of a Maquiladora Regime was developed and nurtured step by step by the Mexican government, oddly in the days of a high government controlled economy, and where the substitution of exports was the name of the game. This new regime started the most liberal free trade system ever developed in Mexico and in many parts of the world, which main features were designed to:
- •Have a duty free and tax free regime of temporary importations of all that was needed to carry out assembly of manufacturing activities (later on export services activities were added as well).
- •Have a simple business structure, where a Mexican subsidiary was created, that would operate basically as a branch, i.e. under a cost center mode vis-à-vis a profit center, where the parent company or corporate related company would nourish the maquiladora of funds needed to operate the Mexican side of the system, such as payroll, utilities, fuels, rents and other inputs, consigning the materials and components and the machinery and equipment. The ownership of those items stayed in the books of the parent company.
- • The income taxes where set as a mere "formality" where the maquiladora would operate using a "token profit". Because the main purpose of the program, was "to create jobs in the northern borders, and not to become a tax generating cow for the Mexican government.
After those happy days went by, in the early nineties, the world of "transfer pricing" came about in Mexico and the pressure from the OECD countries made Mexico to forget about these tax liberalities. So Mexico entered into the famous US/Mexico Mutual Agreement for transfer pricing matters, principally focusing on maquiladora activities. In the year 2001, Mexico's Congress passed a special tax regime for maquiladoras as follows:
•The "token profit" system was abolished, and changed into an arrangement where special transfer pricing formulas where created to come to a universally accepted tax basis under which maquiladoras would pay taxes. Such formulas where based under four methodologies that we will simply and briefly describe:
- Safe Harbor: the tax basis is set at the highest of:
- •6.5% of all cost and expenses, or
- •6.9% of all dedicated assets of the maquiladora activities.
- Advance Pricing Agreement: where the maquiladora and the government made a single country (Mexico) or multiple country agreement (i.e. US/Mexico), to arrive at a mutual acceptable tax basis.
- An OECD 's acceptable transfer pricing acceptable mark-up, plus an addition return on assets mark-up.
- An OECD's acceptable transfer pricing acceptable mark-up, plus 1% of the value of the maquiladora dedicated machinery and equipment.
• Finally, as a result of negotiations with former Presidents Fox and Calderon, the maquiladora leadership obtained special Executive Orders under three different decrees, where the combined income tax and IETU (Special Business Single Tax Rate), where
caped at a rate of 17.5% of taxable income.
Now, the recently passed tax reform severely disrupted the well balanced special tax regime for maquiladoras that was developed principally to maintain its worldwide competitiveness. These changes are basically the following:
- The special tax rate was increased from 17.5% to 30%. (And an additional dividend tax of 10% was imposed.)
- The elimination of the OECD based methodologies to establish the maquiladora tax basis.
- The lowering of the deductibility of labor benefits for income tax purpose from 100% to 57%.