BAKER & McKENZIE ABOGADOS, S.C.

MAQUILADORA TRANSFER PRICING

Jaime Gonzalez-Bendiksen
Baker & McKenzie
Juarez, Tijuana, Monterrey

Introduction

Mexico has had transfer pricing rules in its Income Tax Law ("ITL") for a good number of years. However, such rules had not been enforced in the international arena. The reason is quite simple: following the economic models then prevailing, Mexico had a "closed" economy for years. Imports, foreign investments, the licensing of know-how, trademarks, patents and the like as well as technical assistance, management advisory consulting and supervisory services were subjected to strict limitations and controls. At some point in time we ever experienced exchange controls. Thus, no tax control of transfer pricing was necessary. But with the "opening up" of Mexico's economy by liberating imports, relaxing limitations on foreign investments and eliminating controls on know-how, technology, trademarks, patents and the like, transfer pricing controls have become necessary as in any developed country. In preparation for the moment to implement such controls, new pricing controls provisions for transactions between related parties were incorporated to the ITL in 1992.

It was in 1995-that actual transfer pricing implementation began. The sector chosen to begin enforcement was that of "maquila" operations, who had henceforth been simple cost centers. Maquiladoras were expressly required by a December 1994 tax amendment to comply with the transfer pricing obligations set forth in the law as from January 1 1995. In plain terms, this means that maquiladoras who manufacture or assemble for related parties must charge, as from January 1. 1995, at arm's length for their services That is, maquiladoras shall cease to be cost centers to become profit centers

This document discusses transfer pricing for maquiladoras as well as certain assets tax and permanent establishment implications thereof.

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Neutral Change

Although, it is not guaranteed that there will be no financial impact on the overall US Mexico maquila transactions, in general terms what implementation of the transfer pricing provisions means is that a portion of the overall profits from the manufacture or assembly of products in Mexico and their subsequent sale into the US or any other market, will be shifted from the US into Mexico, as seen in the following chart:

Maquiladora as Maquiladora as

Cost Center Profit Center Sales price 1300 1300 Maquiladora costs1000 1000 Maquiladora profit10 50

US costs 100 100

Total costs 11 10 1150 US profit 190 150

Summary

Profit in Mexico taxed @ 34% 10 50 Profit in USA taxed @ 35% 190 150

Further, although subject to all limitations in the Internal Revenue Code and Regulations, and consequently not necessarily a dollar for dollar credit, income taxes paid in Mexico by the maquiladora should generally qualify for foreign tax credit for the US entity.

Transfer Pricing Compliance Options

1. ITL Provisions.

Under the ITL, maquiladoras should charge at arm's length for their maquila activity

and keep contemporaneous documentation to support such charges. No notices are

required to be filed with the Ministry of the Treasury (the "Hacienda") in order to comply with this statutory obligation

2. General Rules "Safe Harbor"

In order to facilitate compliance by maquiladoras, item 3.33.1 of the General Rules

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issued on March 21, 1997 ("General Rules") set forth two options. The first option gives maquiladoras a transfer pricing "safe harbor". Under this option, maquiladoras will be deemed to have complied with arm's length prices if they generate a taxable profit for tax year 1997 equal to or greater than 5% of the value

of all assets used in the maquila activity. It is questionable whether inventory can be excluded from this calculation (although it may be excluded for computing the asset tax as discussed below). A conservative approach would recommend that inventory

be considered in the 5% calculation. This safe harbor benefits labor-intensive operations.

The asset values for purposes of the 5% calculation are determined in accordance with the provisions in the Assets Tax Law ("ATL"), namely:

a. Financial Assets: The sum of the monthly averages for the tax year, divided by the number of months in the tax year. The monthly averages are arrived at by adding the financial assets at the beginning and at the end of the month and. dividing the result by two. The monthly average of financial assets originating from transactions with or through the Mexican banking system is calculated

by adding up all daily balances during the month and dividing the result by the number of days in the month.

b. Fixed assets: The value declared in the import manifest ("pedimento") less the depreciation that would have applied under the ITL from the date of the import "pedimento" up to the year preceding that for which the asset tax is being calculated. The balance after this theoretical depreciation is adjusted for inflation from the month in which the goods were imported up to the last month of the first half of the tax year. This adjusted amount is then reduced by half of the depreciation that would apply under the ITL for the tax year in question. For assets imported during the tax year, the import "pedimento" value is adjusted for inflation as indicated above, this result is to be divided by twelve and the quotient multiplied by the number of months in the tax year during which the assets were used

As. an exception, constructions and machinery and equipment added in

expansions are excluded until such time as they begin generating income.

c Intangibles: In principle, the value of intangible (e.g. patents, know-how) is determined similarly to fixed assets. However, the General Rules allow the maquiladora to elect whether or not it wishes to include the intangibles in the basis for the 5% safe harbor.

d. Land: The original investment amount, adjusted for inflation from the month in which it was acquired through the last month of the first half of the tax year. If the land was acquired during the tax year, the above result is divided by

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twelve and the quotient is multiplied by the number of months in the tax year during which the land was owned.

e. Inventory: The value of inventory kept in Mexico for less than one year is determined by adding the value reported in the import "pedimento" and the value declared in the export "pedimento", dividing this result by two, further dividing this result by 365 and multiplying the quotient by the number of days the inventory was physically in Mexico.

As an option, maquiladoras may add the monthly inventory averages of the tax year and divide the result by the number of months in the tax year. For these purposes, the monthly average is the result of adding the inventories at the beginning of the month, he inventories at the end of the month, and the costs and expenses incurred in the maquila activity during the month, and dividing the result by two. The inventories at the beginning and at the end of the month should be valued using the values declared in the import "pedimentos".,

From the above asset values maquiladoras may subtract the amount of certain debts with entities residing in Mexico or with permanent establishments in Mexico of foreign entities. Debt with foreign creditors or with Mexican banks cannot be used to reduce the basis for the 5% safe harbor.

To qualify for the safe harbor, maquiladoras are required to file a notice before the Hacienda, not later than May 31,1997, indicating that they expect their taxable profit (before loss carryforwards) for 1997 to represent at least 5% of the value of the assets they use in their maquila activity. Maquiladoras beginning operations after May 31, 1997 may still elect the 5% safe harbor by filing a notice before the Hacienda not later than December 31,1997.

On or before April 30, 1998, maquiladoras must file a second notice before the Hacienda, indicating the percentage the taxable profit actually obtained in 1997 represents with respect to the aforementioned assets.

Maquiladoras are required to keep the documentation supporting the calculations

referred to in the notices indicated in the two preceding paragraphs, at the disposition of the Hacienda.

When the 5% safe harbor is met, maquiladoras will be deemed to have complied

with their transfer pricing obligations for 1997.

3. General Rules "Advance Pricing Agreement"

The second option in the General Rules is quite simple. When maquiladoras expect

their taxable profit to represent less than 5% of the value of the assets they use in their maquila operations, they must file a letter to the Hacienda to this effect, not later

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than May 31, 1997, and file, on or before December 31, 1997 a request for the Hacienda to decide that the prices the maquiladoras have determined are at arm's length (a so-called "Advance Pricing Agreement" or "APA") ). Where the APA is secured, maquiladoras will, of course, be deemed in compliance with the transfer pricing provisions. Maquiladoras beginning operations after May 31, 1997 may elect the APA option and file for the APA not later than December 31,1997.

Clearly, this option is preferable for capital-intensive operations.

C. Transfer Pricing Study

Maquiladoras should perform a transfer pricing study to determine what their arm's length prices should be, in any of the following cases:

Under the ITL provisions, if they intend to comply with the transfer pricing

obligations without electing any of the options in the General Rules.

Under the General Rules Advance Pricing Agreement option 2.

No transfer pricing study is required if Option I is elected.

Note that when a transfer pricing study is performed and backed up with supporting documentation, the penalty in the event of a tax deficiency resulting from improper transfer pricing is reduced by one half.

Tax and Penalties

Failure to comply with transfer pricing may result in the prices charged for the maquila activity being recomputed and thus having presumed profits. The impact of such presumed profits could conceivably be substantial, as taxes, penalties and surcharges could be incurred, as follows:

Presumed profits are taxable income and consequently subject to the

general 34% corporate tax rate.

Adjustment of the tax according to the inflation rates calculated from month

the tax should have been paid to the month it is actually paid.

Interest on the two above amounts, for up to 10 years.

A penalty of up to 160 percent of the first two amounts mentioned above.

It is conceivable, although not certain, that residents of Mexico who make payments to nonresidents could be jointly liable for the amount of taxes mentioned in a. above, on the theory that they were obligated to withhold taxes on the presumed income.

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Assets Tax

Overview

Under the provisions of the ATL, the foreign principals of maquiladoras are required to pay a 1.8% Mexican asset tax on all of their assets being used by the maquiladora (financial assets, fixed assets, intangibles and inventories). However, under the U.S. - Mexico tax treaty, if the maquiladoras can be said not to create a permanent establishment in Mexico for the US principal, then inventory would be excluded from this tax.

As the asset tax is similar to an alternative minimum tax where the nonresidents' Mexican income tax can be credited against their asset tax, careful planning should be made to determine the feasibility of generating Mexican income tax to offset the asset tax and of benefiting from the US-Mexico tax treaty, for example, by charging rent for the fixed assets. It is also possible for the maquiladoras to consider the, foreign-source assets as their own for asset tax purposes, include them in their base to compute the asset tax and credit their own income taxes against the resulting asset tax. The above two possibilities would have an added benefit. Mexican asset

tax is not creditable as a foreign tax credit against US federal income tax. But when the asset tax is offset with Mexican income tax, the income tax should qualify as a foreign tax credit, subject to U.S. restrictions and limitations.

Exemption

Notwithstanding the foregoing, when either of the transfer pricing options set forth in the General Rules is elected and lived up to, the nonresident principals will be exempted from asset tax for 1997. Such exemption applies with respect to their foreign-origin assets used by the maquiladoras, except in the percentage that the production of the maquiladoras destined to the Mexican market represents with

respect to the maquiladoras' overall production (thus, e.g. if a maquiladora sells 50% of its production to the Mexican market, only 50% of the exemption will apply). Of course, if no part of the maquiladora production is for the Mexican market, the asset tax exemption applies without limitation.

Where a maquiladora elects either the 5% of assets safe harbor or the advance

pricing agreement but fails to carry the election through (i.e. either because it fails to meet the 5% safe harbor or because it does not file for or secure the advance pricing agreement, the nonresident principals will not be exempted from asset tax and the maquiladora will be jointly liable for such tax.

Permanent Establishment

Maquila operations create a permanent establishment for the U.S. principals under both the U.S. - Mexico tax treaty and the ITL. Having a permanent establishment in

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Mexico may create a number of undesired results. For example, sales by the nonresident principal of the same or similar goods as those sold by the permanent establishment would be attributed to the permanent establishment and taxed by Mexico. Such a permanent establishment can, however, be avoided in certain cases, as discussed below.

ITL Provisions

Under the ITL provisions, if maquiladoras comply with their obligation to charge at arm's length and if the U.S. principals has contemporaneous documentation

supporting such charges(e.g. a transfer pricing study) and submits it to the Hacienda upon request, no permanent establishment will be deemed to exist.

General Rules Safe Harbor

If maquiladoras elect and meet the 5% safe harbor, and if they keep the supporting documentation, they would be complying with the ITL provision mentioned above

and, consequently, would avoid creating a permanent establishment for their nonresident principals. Where the safe harbor is not met and where no ruling evidencing arm's length compliance is secured, the nonresident principals would be considered as having a permanent establishment in Mexico.

General Rules Advance Pricing Agreement

Filing for and securing an advance pricing agreement under this option would comply with the ITL requirements to avoid permanent establishment status.

Respectfully submitted,

1997 Baker & McKenzie

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