Implications for maquiladoras of the 2014 Mexican tax reform

Along with the amendments to the law itself in the 2014 tax reform, President Peña Nieto also published a decree to provide partial relief to the maquiladora industry, The Administrative Tax Guidelines for 2014 and the Administrative Guidelines in Foreign Trade Matters also provide specific requirements for implementation of the law.

To improve its foreign investment competitiveness and take advantage of its strategic location, in the 1960s Mexico adopted a series of tax and customs policies favouring the establishment of wholly owned companies that process or assemble imported materials and parts into finished products for sale to the country of origin or other parts of the world. These companies, commonly known as maquiladoras, today represent a key component of Mexican industry in accounting for an annual average of $190 billion in exports and almost two million direct and indirect jobs. Since 1997, maquiladoras have been required to observe arm´s-length pricing for tax purposes, instead of operating as mere cost centres. In parallel, from a foreign trade perspective, to comply with the North American Free Trade Agreement (NAFTA) commitments, maquiladoras were required to incur and pay applicable duties if the goods they manufactured were destined for a NAFTA member country. Otherwise, they could continue to import raw materials in-bond without having to incur duties. In 2006, President Fox revised the original maquiladora regime and enacted the Decree for the Promotion of the Manufacturing, Maquila and Export Service Industry (IMMEX Decree), which merged the existing maquiladora and temporary import programmes, formerly known as Pitex. The 2006 IMMEX Decree, together with its 2008 and 2010 amendments, provide the general requisites that companies must meet to enter into an IMMEX Programme, and thereby be entitled to the special tax and customs treatment set forth for maquiladoras (IMMEX Programme). In general terms, companies must meet these requirements to obtain an IMMEX Programme: Annual exports of $500,000 ($380,000) or 10% of total sales. Maintain an automatic inventory control system following the first in, first out method. Temporarily import of authorised raw materials and machinery and equipment (M&E) products under the relevant programme. File reports with the Ministry of Economy and the National Statistics and Informatics Institute in Mexico. From a Customs standpoint, companies with an IMMEX programme are entitled to a series of benefits including the duty-free temporary import of raw materials, supplies, fuels, lubricants, spare parts and other consumables used in the production processes, and in general the import of raw materials regardless of their origin. Temporary importation of M&E has for a considerable period of time not been entitled to import duties exemption, however no VAT was levied as long the temporary customs regime did not change. If NAFTA-bound, duties must be paid on, for example, raw materials, parts and components in accordance with the specific provisions set forth by NAFTA and its administrative guidelines. The IMMEX Programme also entitles companies to certain tax incentives, primarily concerning income tax (IT), value added tax (VAT) and special excise tax on production and services (excise tax), which are foreseen under the IT Law, VAT Law and Special Goods & Services Tax Law, respectively and Administrative Guidelines in Foreign Trade Matters.

Maquiladoras must be Mexican legal entities that can be wholly-owned by foreign investors. In general, the typical business structure involves the foreign owner entering into a toll manufacturing agreement with the maquiladora, through which the latter receives M&E, raw materials and consumable supplies, inventory and materials property of the foreign principal on a gratuitous bailment basis, to carry out the tolling, manufacturing or transformation services activities. The legal and contractual relationship between the maquiladora and its foreign principal often results in the creation of a permanent establishment (PE) in Mexico for the latter, under the general PE rules outlined in Mexican domestic law and its tax treaties.

Article 2 of the IT Law in force until 2013, and Article 181 of the new IT Law in effect as of January 1 2014, establish that the economic and legal relationship between a Mexican company performing "Maquila operations" and its foreign principal will not result in a PE for the latter if certain transfer pricing thresholds are met.

For this PE relief provision to apply, the foreign principal must also reside in a country that has a tax treaty with Mexico.

"The new IT Law requires that income for the Maquila operations originates entirely from productive income, without defining what this means"

Until December 2013, the concept of Maquila operations for purposes of the special PE relief was outlined under article 33 of the IMMEX Decree. However, as of January 1 2014 this definition has been incorporated into article 181 of the new IT Law.

Even when the new concept of Maquila operations did not suffer a major modification when compared with that foreseen under the IMMEX Decree, two important amendments are notable.

Articles 11 and 24 of the IMMEX Decree require that the maquiladora export a minimum of 10% its total sales, allowing for definitive import and sale of products to the Mexican market representing 90% of their total output.

Though the IMMEX Decree remains in force, for the PE relief provisions to apply, the new IT Law requires Maquila operations to export 100% of the finished products that were imported temporarily even if these products are exported virtually.

The new IT Law requires that income for the Maquila operations originates entirely from productive income, without defining what this means. This uncertainty is clarified through the Administrative Tax Guidelines 2014, which establish that income will be considered as exclusively deriving from export Maquila operations if it arises from the rendering of Maquila services to foreign resident related parties. This provision intends to be comprehensive rather than restrictive, since it further establishes that income received from activities related to its Maquila operations must also be considered as productive income, if the income's accounting is duly segregated from the manufacturing income as well as the related costs and expenses. As an example, if a Maquila company leases out excess building space within its facilities, such income could be considered as associated with its Maquila activity and therefore be treated as Maquila related productive income.

However, this rule also establishes that income from the sale and distribution of finished products will not be considered as productive maquila income. This includes income derived from the sale of products not manufactured by the maquiladora or from the acquisition of products to be imported and further sold in Mexico, even if such products are acquired separately or jointly with other products not manufactured by the maquiladora. The rule clearly reflects the position of the tax authority, making it clear that it wants to avoid maquiladora operations that benefit from a preferential regime being involved in commercial trading activities.

It should be noted that these provisions must be interpreted based on the last paragraph of article 182 of the IT Law, which establishes that maquiladoras performing maquila and non-maquila activities may only benefit from the safe harbour provisions for the portion of the income that corresponds to maquila operations.

Therefore, under a comprehensive interpretation of article 182 of the IT Law and the Administrative Tax Guidelines 2014, together with the legal principle establishing that "if not specifically forbidden must be deemed as permitted", makes one conclude that only the forbidden sales and distribution activities in the Mexican market will affect the productive income nature of maquiladoras, to comply with the 100% export requirement. Other income not related to the maquila activities which neither derives from sales and distribution activities in Mexico will not affect the 100% productive income threshold.

However, this latter income shall not be subject to special transfer pricing safe harbour rules under the IT Law, therefore being required to abide to a segregated PE liability analysis under general PE rules and subject to ordinary transfer pricing provisions to demonstrate arm´s-length pricing.

Note that under transitory provisions of the Administrative Tax Guidelines 2014 the new 100% export requirement is applicable as of July 1 2014. Until then, Maquiladoras may perform maquila operations under the 10% minimum export requirement established in the IMMEX Decree.

Under the concept provided by article 33 of the IMMEX Decree, for an activity to qualify as maquila operation, the foreign principal entering into the toll or manufacturing agreement with the maquiladora must own at least 30% of the M&E used in the maquila operation. Companies granted an IMMEX Programme before December 31 2009 were grandfathered from complying with this requirement.

The new IT Law also includes the minimum ownership percentage requirement, however does not include the grandfathering provision excluding companies with an IMMEX Programme issued before December 31 2009. Therefore upon the entry into force of the new Income Tax Law on January 1 2014, all companies must comply with this requirement to qualify as performing Maquila operations.

Even so, a presidential decree granting certain tax incentives to the manufacturing, maquiladora and export services industries, published on December 26 2013 (the 2014 decree), provides a two-year period from January 1 2014, for companies operating an IMMEX Programme issued before December 31 2009 to comply with the minimum ownership percentage requirement. If the maquiladora complies with this requisite during the grandfathered period, it will continue to qualify as performing maquila operations. Companies that fail to comply with this requirement during this two-year period will be considered not to perform maquila operations as of the third year and thus, not entitled to the PE shelter under the IT Law.

As explained above, maquiladoras are companies that assemble or manufacture goods using temporarily imported materials for their further export, generally using M&E provided by the foreign principal. Formerly, maquiladoras were treated as cost centres with a null tax liability in Mexico. However, from the mid-nineties maquiladoras have been required to comply with transfer pricing rules, either by considering an arm's-length profit or applying special safe harbour rules which have changed over time.

Under the IT Law in force from January 1 2014, the options available for maquiladoras' transfer pricing compliance are limited to:

• Safe harbour rules. The presidential decree dated October 30 2013 that allowed maquila companies to calculate their taxable base considering the highest value between 3% of assets used in the maquila activity or the total operating costs and expenses, has been repealed. Therefore, safe harbour rules for 2014 and onwards provide that maquila companies must calculate their taxable basis by considering the highest value between 6.9% of their assets or 6.5% of their costs.

• Advanced pricing agreement (APA). The option to file the tax authority with an arm's-length margin proposal through an APA exists.

Consequently the 2014 reform has repealed these pricing options available for maquila companies for 2013 and prior fiscal years:

• Markup method. Consisting of the option to prepare and maintain transfer pricing studies that consider the arm's-length level of profitability added with 1% on the net book value of M&E owned by the foreign principal and used in the maquila activities.

• Return on foreign assets. Consisting of the option to prepare and maintain transfer pricing studies considering a return on assets, including those owned by the foreign principal that were used in the maquila activities.

The new IT Law states that taxpayers may only deduct 47% of payments to their employees qualifying as exempt income for the latter, such as saving funds, food coupons, and certain social welfare. This limitation increases to 53% when the taxpayer does not reduce fringe benefits paid to employees in comparison to those paid on the previous tax year.

Fortunately for maquiladoras, the negative impact caused by this deductibility limit is reduced by the 2014 decree, which grants a tax incentive for taxpayers performing maquila operations as defined under the new IT Law, as an additional income tax deduction equal to 47% of payments made to employees qualifying as exempt income for the latter.

As a result, companies performing maquila operations may completely offset the negative impact of the deductibility limit established under the new IT Law if they are entitled to a deductibility percentage of 53% not reducing fringe benefits compared to those granted in the prior tax year.

Otherwise, companies with maquila operations entitled to the 47% deduction may only deduct 94% of exempt employee payments considering the additional 47% deduction established by the decree.

Note that the additional deduction applies to the proportion of the total activities of taxpayers that qualify as maquila operations under the definition of such concept established by the new IT Law. Therefore, payments made by a maquiladora to employees that carry out activities outside the scope of maquila operations will only be deductible at 47% or 53%. As of today, no procedure for allocating payments among maquila employees has been established. Companies with an IMMEX Programme that fail to meet the requirements to perform maquila operations under the new IT Law are not entitled to this tax incentive.

Note, however, that if the maquiladora is structured to avoid creating a PE (that is, by having the M&E owned by the Mexican maquiladora and not having employees of the foreign principal located at the premises, then it will neither be forced into the 100% export requirement nor will it be subject to the transfer pricing safe harbour rules. Instead, it will be subject to the general export quota requirements set forth under the IMMEX Decree and the transfer pricing provisions of the IT Law

Under the amendments to the VAT Law in force as of January 1 2014, the exemption, for companies with an IMMEX Programme or related to the automotive or manufacturing industries, for transfers by foreign residents of temporarily imported goods or bound to a bonded warehouse, has been repealed.

Consequently, those companies must withhold and pay the creditable VAT at the 16% rate, and defer crediting of such VAT until the monthly VAT return filed in the month after that in which VAT was actually paid, thus resulting in a financial burden.

Fortunately, the 2014 decree allows eligible companies to credit VAT in the same monthly return in which the VAT withholding is reflected, avoiding the negative cash flow implications that would arise without such relief.

The immediate VAT crediting benefit is available to all companies with an IMMEX Programme or similar Customs regimes, and those of the automotive or manufacturing industries, that purchase goods that are either exported, imported under an IMMEX Programme, held in a temporary import regime or a bonded warehouse.

For this benefit to be applicable these goods must correspond to a supply chain of products bound for export, and the necessary documents to evidence such status are available. Under the 2014 decree´s transitory provisions, from January 1 2015 immediate VAT crediting is only to be available to companies that receive a certification from the Mexican tax authorities.

Under the amendments to the VAT Law and Excise Tax Law, the exemption on temporary imports is repealed as of January 1 2015. However, a tax credit is granted for companies that receive a certification from the tax authorities, through which the additional tax liability on temporary imports is offset.

The rules and procedure for certification were published on January 1 2014 as an amendment to the Administrative Guidelines in Foreign Trade Matters, whereby a three-tier system for certification is established, in which each tier (A, AA and AAA) has its own requirements and benefits (see Table 1).

Table 1
Tier A – One year certificate
Benefits	Most important requirements
• Tax credit to offset VAT and excise tax on temporary imports. • VAT refund in a 20-day period. • Renewal of certificate through 30 day prior notice.	General requisites • Hold proper inventory control systems. • Have an initial compliance inspection by customs officials. In case of taxpayers with an IMMEX Programme. • Have the necessary infrastructure to perform the IMMEX Programme activities. • Evidence that during the past year, value of the transformed products was at least 60% of the value of the temporary imports performed in the same year.
Tier AA – Two year certificate
Benefits	Most important requirements
• Tax credit to offset VAT and excise tax on temporary imports. • VAT refund in a 15-day period. • 30-day term for self-correction prior to a tax audit. • Obtain a self-compliance invitation from tax authorities before a formal audit. • Renewal of certificate through 30 day prior notice.	In addition to Tier A requirements: • Have at least 40% of their maquila operations performed in Mexico in the previous fiscal year with suppliers holding a positive opinion letter issued by the tax authorities. • Have performed maquila operations during the past five years or have held an average of 1,000 employees during the previous year, or machinery and equipment with a value greater than MXP$50 million. • No tax assessments were served during the prior 12 months to the certification request filing, or if assessments were served, these were either fully paid or a monthly tax payment plan set into place. • No VAT refund was denied during the prior 12 months.
Tier AAA – Three year certificate
Benefits	Most important requisites
• Tax credit to offset VAT and excise tax on temporary imports. • VAT refund in a 10-day period. • 60-day term for self-correction before a tax audit. • Obtain a self-compliance invitation from tax authorities prior to a formal tax audit. • File consolidated customs manifests. • Avoid information regarding serial number of temporary imported goods for customs procedures. • Perform export customs clearance procedures from its domicile.	In addition to the Tier A and Tier AA requisites: • Have at least 70% of their maquila operations performed in Mexico in the previous fiscal year where performed with suppliers complying with the positive opinion above. • Have performed maquila operations during the past seven years or hold an average 2,500 employees during the prior year, or have held machinery and equipment with a value greater than MXP$100 million. • No tax liability was assessed on them during the 12 months before the certification request, and if assessed, has been paid in full or a monthly tax payment plan was concluded. • No VAT refund has been denied during the previous 12 months.

Eligible entities may file the request for certification through the website (www.ventanillaunica.gob.mx). Certification requests must be filed between April 1 and October 22 2014, based on the maquiladora company's tax domicile and jurisdiction of the Regional Departments of Auditing and Foreign Trade (ARACE in Spanish):

Companies/ARACE's jurisdiction	Period for certification requests
Certified companies and those operating under the bonded warehouse for vehicle production process regime.	April 1 to April 30
North Pacific	April 15 to May 15
Northeast	June 3 to July 3
North Central	July 7 to August 7
Central	August 7 to September 8
West and South	September 22 to October 22

Additional rules to clarify the diverse requirements for certification, were published in February 27, 2014. These provisions are intended to provide more detail on the conditions of such certification regarding labour compliance and export percentage calculation.

Ricardo León-Santacruz (rls@sanchezdevanny.com) is a partner, based in Monterrey, and Fernando Lujan (fl@sanchezdevanny.com) is an associate, based in Mexico City, of the tax practice group of Sánchez-DeVanny Eseverri.
The authors would like to thank their colleagues Turenna Ramirez and Jose Alberto Campos, partners of the Customs and foreign trade practice for their valuable insight in the preparation of this article.