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February 23, 1999
This is a response to your request at our meeting on February 11, 1999, for a written statement of the particular concerns that have led CNIME to propose that SHCP restore the rules that have clarified when a foreign company contracting with a maquiladora or a PITEX company has a tax presence (a "permanent establishment") in Mexico. This statement does not address CNIME’s request that SHCP reverse the recent changes in the application of the Mexican value added tax to transactions involving companies in the maquiladora industry.
The rules that Mexico has repealed previously provided a clear definition of the circumstances in which a foreign company that uses the processing services of a maquiladora or a PITEX company has a permanent establishment in Mexico. The effect of those provisions has been to apply the normal definition of permanent establishment, which generally applies to a foreign company under Mexico’s tax treaties, to US companies participating in the maquiladora and PITEX industries, provided that they make arm’s-length payments to the Mexican company.
The rule that has provided this clarification for the maquiladora industry is a transitory provision related to Article 2 of the Mexican income tax law, which has provided that a foreign company does not have a permanent establishment as a result of acting in Mexico through a maquiladora company unless the foreign company has a fixed place of business or unless it has a dependent agent in Mexico that has and exercises the power to conclude contracts on behalf of the U.S. company. The effect of the repeal of that transitorio is to create significant uncertainties for U.S. companies using the processing services of a maquiladora as to whether they will have permanent establishments in Mexico, and as to the Mexican income tax consequences if they do have such a permanent establishment. Those uncertainties already exist for a U.S. company contracting with a PITEX company, as a result of Mexico’s revocation of the regulations containing a similar clarification of the Mexican tax treatment of a foreign company using the processing services of a PITEX company.
If the transitorio is not restored for the maquiladora industry and expanded to cover U.S. companies using the processing services of a PITEX company, these uncertainties will create substantial additional costs for such U.S. companies that will not apply to other U.S. companies or to companies from other treaty countries that use the processing services of a maquiladora or a PITEX company.
It appears that SHCP does not fully appreciate the adverse consequences of its repeal of this transitorio and the revocation of similar rules for the PITEX industry. These adverse consequences include the following:
1. An uncertain climate for U.S. companies conducting business activity with Mexican companies in the maquiladora and PITEX industries. This uncertainty concerns both the inability of a U.S. company to determine whether or not a permanent establishment may be found to exist in a particular instance and what the Mexican government may assert its tax liability to be under the new rules. Overall this uncertainty will also tend to undermine the sense of reliability of Mexico’s tax policies, given the willingness of the Mexican government to dramatically change its tax policy for this industry after U.S. companies have committed substantial investments.
2. Double taxation by Mexico and the United States of net income of the U.S. company that Mexico chooses to tax, which could cause a combined income tax rate of 75% on such income.
3. Significant increases in administrative costs for U.S. companies participating in the maquiladora and PITEX industries, in the event that Mexico attempts to change their tax treatment.
4. Unequal treatment of U.S. companies utilizing the processing services provided by the maquiladora and PITEX industries, because those U.S. companies will be subject to potentially more onerous permanent establishment rules than those that apply to other U.S. companies or to companies from other countries that have a tax treaty with Mexico.
5. Significant new costs for U.S. companies participating in the maquiladora and PITEX industries in analyzing alternatives for restructuring those operations to minimize their exposure to the costs and uncertainties relating to permanent establishment issues.
Cumulatively these factors are likely to have a profoundly negative effect on the decisions of many foreign companies on investing in these sectors in Mexico. The effect of the changes is likely to particularly severe because they come at a time when Mexico is facing increasing competition for all kinds of processing operations form other countries, particularly those in Central America and Asia.
A. Uncertainty
Repeal of the transitorio on permanent establishment treatment for U.S. companies involved in the maquiladora industry, and the similar rule for U.S. companies involved in the PITEX industry, creates substantial uncertainty for U.S. companies that utilize the processing services of a maquiladora or a PITEX company or that are considering the use of such processing services in the future.
First, U.S. companies will have difficulty knowing either when they will be considered to have a permanent establishment in Mexico associated with the use of a Mexican company to provide processing services or what standards the government will apply in that case to make that determination. While the change in the rules will not automatically cause all U.S. companies in the industry to have a permanent establishment, it is unclear how Mexico will apply the new rules. If, however, the government attempts to impose tax on income of such U.S. companies in the industry on the basis that they now have a permanent establishment in Mexico, many companies will challenge that conclusion.
No matter how broadly the domestic rules are interpreted, they cannot supercede the treaty standards. In order to find that a U.S. company has a permanent establishment, the treaty rules will require a determination of whether the maquiladora is a dependent or independent agent. If the maquiladora or PITEX company is operating at arm’s length with the U.S. company, it could be viewed as an independent agent under the Mexico-U.S income tax treaty, in which case no permanent establishment would be deemed to exist under the treaty. Furthermore, even if the treaty requirements for having a permanent establishment were met, there would be other contentious issues in determining whether Mexico could find the US company to have a permanent establishment under Mexican law. Thus, if Mexico assumes a more aggressive posture on these issues, the industry is likely to be embroiled in uncertainty and controversy on this issue for a long period.
Second, even if a U.S. company does acquire a permanent establishment in using the processing activities of a maquiladora or a PITEX company, it is not clear whether any additional net income should be attributed to that permanent establishment. As long as the fees paid to the maquiladora for its processing services are arm’s length, the full amount of the income associated with the activities of the Mexican company has been taxed in Mexico. It is far from clear whether the Mexico-U.S. income tax treaty would allow any additional income to be attributable to a permanent establishment of the U.S. company that is merely deemed to exist under the treaty as a result of the processing activities of the maquiladora or PITEX company. Nevertheless, Mexico’s repeal of the transitorio creates uncertainty for US companies on this point because it suggests that Mexico may adopt a different view on this issue as well.
It is significant that the these uncertainties are not likely to be resolved quickly if Mexico decides to change the rules as a basis for expanding its notion of when a U.S. company will have a permanent establishment. Mexico has in the past recognized that unresolved uncertainty can quickly have a damaging effect because, once a U.S. company has identified a significant uncertainty, it will tend to factor the potential negative result as an assumption into the projections that it uses as the basis for strategic decisions such as decisions about where to locate its productive capacity.
At a more fundamental level, many U.S. companies have reacted with alarm to this abrupt change in what they had understood to be a stable tax regime based on the understandings previously reached between the government and the industry. The sense of stability or continuity in this and other cost factors in Mexico has undoubtedly contributed to the extraordinary growth and popularity of the maquiladora industry in recent years. Mexico’s sudden decision to change its tax posture for these US companies in an unfavorable manner, without taking into account the administrative and tax cost of the change, will undoubtedly cause US companies to reconsider their existing and future plans for conducting such operations in Mexico.
B. Double Taxation of the Same Income by Mexico and the United States
Apart from the chilling effect that uncertainty has on business growth, there is a serious prospect in this case of systematic double taxation by both Mexico and the United States on net income of the US company that the Mexican government claims to be attributable to a permanent establishment. Such double taxation of the same income by Mexico and the United States would result in a total effective income tax rate of 75% on the income in question.
This double taxation would result from the fact that in the case of sales to U.S. customers of products processed in a maquiladora or a PITEX company, the U.S. tax rules would generally treat a U.S. company’s income from such sales as U.S. source income, notwithstanding the fact that the U.S. company has utilized the processing services of a maquiladora or a PITEX company in Mexico. That would prevent the U.S. company from claiming a U.S. foreign tax credit for any Mexican taxes paid on that income.
Generally a U.S. foreign tax credit is available to allow a U.S. company to offset payments of foreign income tax against the U.S. company’s U.S. income tax liability. The U.S. foreign tax credit, however, is limited to the U.S. income tax liability on the U.S. company’s foreign source income. The IRS has interpreted the U.S. source-of-income rules that apply in this case as treating as U.S. source income all of the income from sales to U.S. customers of goods processed in a maquiladora or a PITEX company that is treated as a corporation for U.S. tax purposes. That has the effect of systematically denying a U.S. foreign tax credit for Mexican income tax imposed directly on the U.S. company on income from the sale of the goods processed with the assistance of the maquiladora company. Therefore, contrary to public statements of Mexican tax officials on this issue, the Mexican changes would systematically lead to double taxation by Mexico and the United States of income that Mexico attempts to attribute to a permanent establishment in excess of the arm’s length compensation paid by the US company to the maquiladora or PITEX company for its manufacturing services.
The U.S. source-of-income rules that would have the effect of denying a foreign tax credit in this case are those appearing in Treasury Regulations Section 1.863-3, issued under Section 863(b) of the Internal Revenue Code, for determining the amount of foreign source income of a U.S. company from manufacturing products partly inside and partly outside the United States. The IRS takes the position that the regulations that could treat a portion of the income as foreign source income do not generally apply in the case of a company that merely uses the processing services of a maquiladora company or PITEX company in processing the products in Mexico.
Treating all of the income from the U.S. sales of products processed by a Mexican company in Mexico as U.S. source income eliminates the U.S. foreign tax credit for Mexican tax imposed on that income. This is because a U.S. taxpayer with no foreign source income is by definition entitled to no U.S. foreign tax credit under the statutory formula for computing the limitation on the credit. When a U.S. company has no foreign source income, the maximum U.S. foreign tax credit is determined as follows:
Maximum U.S. foreign tax credit = foreign source net income / total net income * Federal income tax liability
= 0 / total net income * Federal income tax liability= 0
This factor alone would make the prospect of having a Mexican permanent establishment under these circumstances unacceptable for most U.S. companies.
Consider, for example a U.S. company that has $10 million in revenue and $2 million in U.S. taxable income per year from selling US customers products processed in a maquiladora. The U.S. income tax on that income is approximately $700,000, applying the U.S. corporate income tax rate of 35%. If Mexico were to decide that $200,000 of that U.S. company’s net income is attributable to a permanent establishment in Mexico, it would impose Mexican income tax of approximately $80,000 on that income of the U.S. company, applying the new Mexican corporate tax rate of 40% on distributed income. If the U.S. does not grant a foreign tax credit for that Mexican tax, the U.S. tax on that same $200,000 would continue to be approximately $70,000 [= 35% x 200,000]. The total tax on that $200,000 of income would in that case be $150,000, for a total tax rate of 75%, rather than $70,000, as would have been the case if the Mexican tax had not been imposed.
C. Administrative Costs
Administrative costs are an important factor for any competitive business operating in a global industry. Small changes in costs can have a big impact on a company's decision as to where to locate its operations. Cost considerations of this kind are particularly important for companies, large and or small, in deciding whether to contract with a particular foreign affiliate to play a role in manufacturing the company’s products. Indeed many companies already have access to facilities in several countries and can easily move production from one country to another.
Furthermore, it is always important to remember that approximately 80% of the companies in the maquiladora industry are relatively small companies, which are particularly vulnerable to cost increases and to uncertainty. Substantial cost increaeses would take a heavy toll on those companies and on their employees.
If Mexico attempts to change the tax treatment of U.S. companies that contract with maquiladoras or PITEX companies, substantial additional administrative costs will most likely result for such a U.S. company. If SHCP asserts that the new rules justify taxing any substantial portion of the U.S. company’s income, those additional administrative costs will generally be large relative to the size of the Mexican operations in question. Many U.S. companies are likely to conclude that the costs of implementing the new rules will be prohibitive.
1. Costs of disputes about whether the U.S. company has a permanent establishment
Absent the requested clarification, these extra costs would include substantial costs of undertaking lengthy disputes with the SCHP as to whether the U.S. company has a permanent establishment under the Mexico-U.S. tax treaty and under Mexico's complex permanent establishment rules. For some companies these costs would include the costs of pursuing competent authority proceedings involving the U.S. and Mexican tax authorities to interpret the permanent establishment provisions of the Mexico-U.S. tax treaty if Mexico interprets those provisions of the treaty to allow it to impose additional tax on the U.S. company.
2. Costs of dealing with any attempt to attribute additional income to the permanent establishment
In the event that a U.S. company is treated as having a permanent establishment in Mexico as a result of the processing activities of a maquiladora or a PITEX company, it is not clear that any additional income should be attributed to the permanent establishment if the U.S. company has properly provided arm’s length compensation for the maquiladora or PITEX activities in Mexico. U.S. companies have already incurred substantial cost to demonstrate to the Mexican government that its compensation for the processing services carried out in Mexico by maquiladoras is arm’s length.
Mexico has indicated, however, that if it finds such a U.S. company to have a permanent establishment, it will attempt to attribute income to the permanent establishment over and above the amount of arm’s-length compensation paid for the maquiladora activities. That process would most likely generate protracted controversy with SHCP for many companies in the industry.
The procedure that Mexico has suggested it would use would be to create a hypothetical division of the U.S. company into two companies, one of which represents the permanent establishment. After determining how the U.S. company should be divided, Mexico contemplates determining the hypothetical net taxable income of the hypothetical company representing the permanent establishment, presumably allocating costs and using some sort of transfer pricing analysis to determine a hypothetical price on hypothetical transactions between the two companies.
One major element of the uncertainty resulting from Mexico’s repeal of the transitorio is the profound uncertainty about how Mexico would pursue this process for a particular taxpayer. Most companies would actively resist any attempt to attribute substantial net income to the permanent establishment on the basis that such a result would in most cases be inconsistent with the economics of the situation.
Note that this transfer pricing analysis and allocation of costs would be totally separate from, and in addition to, the transfer pricing analysis that would still need to be employed by the U.S. company to determine the price to be paid to the maquiladora or PITEX company for its manufacturing services. That payment should be deductible in determining the net income, if any, that is attributable to the permanent establishment.
It is difficult to estimate the magnitude of the added costs that a company would incur to establish whether any additional income should be attributed to the permanent establishment, and arguing with SHCP about the results of such analysis, given the hypothetical nature of the calculations. The costs of undertaking the analysis would be substantial, and the costs associated with the controversies that would likely result would be enormous. Conservatively one could expect that process to cost several times the amounts that U.S. companies have spent in determining arm's-length fees to pay to the Mexican companies.
D. Unequal Treatment
It is important to understand why Mexico’s repeal of the transitorio and the PITEX regulations has the effect of applying less favorable permanent establishment rules to U.S. companies contracting with maquiladoras or PITEX companies than the permanent establishment rules that will continue to apply to other U.S. companies and to foreign companies from other countries that have an income tax treaty with Mexico.
Until now Mexico, through the transitorio, has in effect applied the normal treaty definition of permanent establishment to a U.S. company doing business with a maquiladora as long as the U.S. company makes arm’s-length payments to the maquiladora. Mexico has accomplished this by including in the transitorio the normal treaty rule that generally requires Mexico to base a conclusion that the U.S. company has a permanent establishment in a case such as this on a determination that the U.S. company has a fixed place of business in Mexico, provided that the U.S. company pays an arm’s-length price to the maquiladora. Mexico had implemented a similar policy for the PITEX industry through the regulation that it revoked on October 15, 1998. Mexico’s former position was appropriate, and it created certainty for U.S. companies.
If the transitorio is not restored, and similar PITEX rules are not reinstated, companies from other treaty countries, including companies doing business with maquiladoras, will continue to be subject to those more favorable rules and will not be subject to the vaguer rules that Mexico is now suggesting for U.S. companies involved in the maquiladora or PITEX industry. This is because those other treaties do not contain the same language as the Mexico-U.S. tax treaty, which Mexico may interpret as permitting Mexico to apply different permanent establishment rules for U.S. companies that obtain processing services from a Mexican company.
Until now Mexico has wisely decided to apply the same permanent establishment rules to all foreign companies from treaty countries that use processing services of a maquiladora or a PITEX company. In the case of U.S. companies, Mexico has implemented that even-handed policy through rules such as those set forth in the transitorio. Restoring those rules, as CNIME has proposed, would preserve such even-handed treatment and avoid potentially placing U.S. companies at a disadvantage relative to their competitors from other foreign jurisdictions.
E. The Costs of Considering and Implementing Restructuring Alternatives
Given the uncertainty, administrative costs, and potential double taxation that U.S. companies would suffer from an attempt by Mexico to impose additional Mexican tax their income from sale of products processed by a maquiladora or a PITEX company, U.S. companies that wanted to continue to conduct their business Mexico would be forced to consider alternatives for reducing those exposures by restructuring their Mexican operations.
This means that each of the 4,000 maquiladoras and PITEX companies and their foreign affiliates would have to bear the cost of analyzing and redesigning their corporate, transactional and pricing structures. The analysis of any such alternatives would need to take into account a complex web of customs, tax, labor, contractual and regulatory issues. Many companies would decide to make changes in the way they did business, and inevitably there would be considerable direct and indirect costs of implementing changes in their existing operations. There would also be the cost of confusion throughout the industry as to what the alternatives would be and how the United States or Mexico would treat any such alternative structures.
It is important to recognize that these costs are different in kind and in scope than the costs of analysis and documentation that companies incurred in implementing arm’s-length pricing standards for maquiladoras. This is because most companies had already structured their Mexican operations with their maquiladoras in a manner that made sense under the new pricing standards.
The costs of such analysis and restructuring will fall particularly hard on the 80% of the industry that consists of relatively small companies. Many such companies will simply not be able to afford the cost of such analysis and restructuring and therefore will be forced either to bear the costs of having a permanent establishment or to curtail their operations.
Since the overall tax regime for the industry was established in 1995, many additional companies have come to Mexico and have structured their operations based on that tax regime.
It is highly questionable whether those companies should now be required to contemplate a potential upheaval in their business operations or whether it is wise for Mexico to embark on a course that would lead to such profound disruption in such an important industry for such questionable benefit in terms of any increases in its tax revenues.