Mexico: The subcontracting conundrum
Mauricio Martínez D´Meza Violante, Ricardo Gonzalez Orta and Gerardo García Franco of Deloitte Mexico discuss how labour laws related to subcontracting in Mexico are set to undergo an evolution, which will create a knock-on effect for tax issues.
The Mexican Congress is discussing new labour legislation that would improve the control of the subcontracting of services in the country. Although the proposed legislation focuses on the labour aspects of subcontracting, some important tax issues also are at stake.
Under Mexico’s Constitution, the Federal Labour Law, and the Income Tax Law, Mexican employers are required to distribute 10% of their profits to all employees on the payroll at the end of the calendar year. Since 2014, such profit sharing has been deductible from the employer’s taxable base, but it is calculated under a special base, which is different from the taxable base used for income tax purposes, and typically results in the payment of profit sharing even in fiscal years in which the company is in a net operating loss position. As a result, the profit-sharing obligation effectively can function as an additional tax on the final results of a company.
To mitigate the negative impact of mandatory profit-sharing, many companies in Mexico have set up legitimate intra-group payroll service companies that are separate from the operating company to house their employees and provide services to the group as a whole (i.e. insourcing).
The structure works as follows: a group establishes a services company to provide personnel (payroll) services to an operating company (and the group) and the operating company pays the services company an arm’s-length amount for the services rendered. This enables the employees to obtain (under the services company’s profit-sharing obligation and additional deductible fringe benefits) a payment similar to what they would have received by way of profit sharing had they been employed by the operating company, and for the operating company to deduct the services payment it makes to the services company (deductibility of the payments has been allowed since 2014). An intra-group services agreement between the services company and the operating company typically is required.
However, some companies have used a different – and sometimes illegal – structure, under which a third party is engaged to manage payroll and some or all of the Mexican company’s employees are transferred to that entity (e.g. outsourcing). These structures have allowed Mexican companies to significantly reduce (or eliminate) income tax and social security payments. These abusive structures have attracted the scrutiny of the Mexican tax authorities (SAT), with the result that the SAT began challenging all structures using a services company – even legitimate ones, giving rise to many disputes between taxpayers and the tax authorities.
Initial response of the government
Although the Mexican government did not condone any of these arrangements, no formal steps were taken for a number of years to curtail them.
However, as noted above, the SAT sometimes exercised its power to disallow deductions or increase a taxpayer’s profit-sharing tax base when it issued an income tax assessment.
In these cases, the SAT typically would provide a copy of the assessment to the labour authorities asking them to pursue the application of the additional profit-sharing base (since profit sharing primarily is a labour-related obligation, not a tax-related obligation), but in practice, follow-up by the labour authorities did not always take place.
The government’s position
A recent push to curtail outsourcing by a member of the Mexican Senate has put the discussion back on the government’s radar.
Although the outsourcing discussions are centred on the profit-sharing conundrum, the discussion has other ramifications, specifically regarding the deduction and VAT credits for payroll costs.
Payroll expenses always have been deductible and any resulting VAT was allowed as creditable for many years, when payments were made to a third party. However, starting in 2012 with President Enrique Peña Nieto’s administration, the SAT began escalating challenges to both insourcing and outsourcing structures, claiming that the payroll expenses by the operating company should not be deductible and VAT should not be creditable, because payroll should be included in the taxable base of the operating company and, thus, deducted as a regular expense and not as a payment to a third party (whether or not related), and no VAT should be charged.
This position created considerable turmoil that resulted in the introduction of rules requiring operating companies that use a separate payroll company to submit an information return with details on the identity of the employees and the payroll company, as well as the employees’ income tax and social security data in order for the operating company to deduct the expenses and claim a credit for VAT.
The government eliminated this rule and amended the VAT law in December 2020, with the new rules requiring operating companies to withhold a 6% VAT (instead of the standard 16% rate) from payments made for labour subcontracting services. The revised rules do not specifically mention outsourcing arrangements but it is clear from the intentions of the executive branch that when it submitted the proposed revised rules to Congress the objective was to limit the use of outsourcing companies to reduce taxation of the employee or the payment of social security contributions.
This withholding requirement is triggered only when the employees of the payroll company can be deemed to directly benefit the operating company and not the payroll company in which they are housed. In other words, a regular service agreement or payroll company arrangement usually would mean that the service provider benefits from the activities of its employees, while performing a service for the client (operating company).
A subcontracting arrangement would mean that the individuals ‘mirror’ being actual employees of the operating company, rather than benefitting their real employer (the service provider) with the rendering of their services. For example, an advisory firm that renders regular advisory services (not subject to withholding), but also renders ‘loan staff’ services (subject to withholding).
The SAT recently issued further guidelines that seem to support this interpretation but also includes frequently asked questions, which in some cases would appear to contradict the guideline, i.e. claiming that a computer maintenance service should be subject to withholding, which would fall, at first glance, within the regular provision of services and, thus, exempt from the VAT withholding.
Intertwining tax and labour requirements
As noted above, while the outsourcing discussion is mainly labour related, it has tax implications. The technical basis for the two areas is intertwined in that the entire issue involves a labour arrangement, i.e. how the employer is legally related to its workforce, depending on how the is set up. This creates a complex situation under which both a labour and tax analysis must go hand-in-hand.
The administration’s goal of curtailing the use of illegal outsourcing arrangements – combined with the intent of certain legislators to limit the use of outsourcing – could result in an uncharted labour and tax environment for potentially affected Mexican companies.
Mauricio Martínez D´Meza Violante
Ricardo Gonzalez Orta
Gerardo García Franco