Mexico’s labour and tax reform: TP collateral implications
Ricardo Rendon of Chevez Ruiz Zamarripa discusses the significant changes introduced in Mexico’s labour and tax reform from a transfer pricing perspective.
Labour and tax reform was published in the Mexican Official Gazette on April 23 2021, contemplating a general entry into force as of April 24 2021, with the exception of certain provisions, such as tax provisions, which enter into force on August 1 2021 (outsourcing reform).
As a result of the amendments to the Federal Labour Law, provisions that governed work carried out under a labour subcontracting regime, also known as outsourcing (which also includes insourcing) were repealed, and under the new provisions those schemes are specifically prohibited.
It is important to mention that as background for implementing this Reform, the Mexican legislators stated that through these schemes outsourcing/insourcing achieved “the perverse effect of preventing workers from benefiting or participating in profits”.
By constitutional right, employers are required to pay 10% of company profit to employees (PTU, as per its acronym in Spanish). The base for PTU is computed on pre-tax income as stated by the Income Tax Law (ITL).
In general, the outsourcing reform now requires that operating entities directly hire all personnel necessary to carry out core business activities and/or the activities for corporate purposes as per the bylaws. Due to this special situation in Mexico, certain group service structures must be discontinued or restructured, otherwise the companies will be at risk since these structures are now prohibited from a labour and tax perspective.
In general terms, under the new legislation the outsourcing of personnel (an insourcing as well), is defined as cases where an individual or legal entity provides or puts at the disposal its own employees for the benefit of another individual or legal entity.
Employment agencies that intervene in the hiring process of personnel may participate in the recruitment, selection, and training, but they would not be considered as employers, since such capacity is held by the individual/entity who benefits from the services provided.
Therefore, the outsourcing reform would impact service company structures between related parties (insourcing), as well as service company structures between non-related parties (outsourcing) as both structures are prohibited by the new legislation.
The outsourcing reform establishes that outsourcing (and insourcing) of ‘specialised services’ or execution of ‘specialised works’ that are not part of the corporate purpose or the main economic activity of the beneficiary is allowed as an exception. This applies as long as the contractor is registered before the Ministry of Labour and Social Welfare (STPS, as per its acronym in Spanish), complementary or shared services (such as the back office) or works provided by companies belonging to the same group are considered as ‘specialised’, considering the concept of business group as established in the Mexican Securities Law.
As a result of the new provisions, a fine will be imposed (2,000 to 50,000 times the value of the unit of measurement and update (UMA, as per its acronym in Spanish), approximately between $9,000 and $225,000) if registration has not been obtained for prohibited outsourcing or insourcing of personnel or outsourcing of services without prejudice of any other obligations that may arise, in which case the STPS will report the facts to the competent authority.
The same sanction will be applicable to those who benefit from outsourcing or insourcing in contravention of the provisions of the new rules on this matter. Additionally, companies face the non-deduction of expenses associated with personnel subcontracting services or the non-creditability of value added tax associated with them and in extreme cases the subcontracting of personnel could be qualified as tax fraud.
As mentioned, the outsourcing reform has an impact on outsourcing and insourcing operating structures, therefore it has a direct impact on a group of companies’ resident in Mexico for tax purposes, that carry out business operations through a service company structure.
The outsourcing reform carries significant implications not only for labour matters and taxes such as income tax and value added tax but also social security contributions, and different legal areas such as corporate, administrative, and even product law in some specific cases, thus this reform should be handled under a holistic approach covering all these different areas.
To comply with the outsourcing reform, a restructure will be required, which may be carried out by merging the service company with the operating company. A merger can be achieved in a tax-free manner subject to certain requirements. However, bear in mind that a merger requires the compliance of several legal requirements and, in general, is effective three months after its registration in the Public Registry of Commerce. The merger may be effective at the time of its registration if it is agreed with the payments of all debts, or a deposit is made of the equal amounts of the debts or a consent is obtained from all the creditors.
Since the restructure has to be ready by August 1 2021 the merger process may be challenging to be achieved on time.
Employer substitution scheme
Another alternative would be to enter into an employer substitution scheme whereby the operating entity as the new employer would assume all labour and employee benefits obligations.
As previously mentioned, there are certain exceptions regarding ‘specialised services’ or execution of ‘specialised works’, in this sense certain new and/or modified service company structures could be implemented to provide back office or shared services within a group.
Furthermore, these insourcing changes may also have repercussions to TP matters in Mexico, since local groups and multinational enterprises (MNEs) would be forced to review current service company structures in Mexico and consideration would have to be made as to whether the new provisions are being complied with. The most likely scenario is a need for a restructure.
Even though there is a ceiling amount of PTU to be distributed per employee (equal to the higher of a three-month salary or the average PTU received in the last three years) in general, an increase in the expenses of the operating companies should be expected coming from an increase in the PTU since employees will now be hired directly by the operating entity.
The increase in expenses in the operating company may have a direct impact in TP because in accordance with the ITL, profit level indicators for purposes of testing the arm’s-length principle, have to be determined based on the Normas de Información Financiera (NIFs, as per its Spanish acronym, which are the financial reporting standards applicable in Mexico).
According to the NIFs D-3, an entity must recognise PTU payments in its income statement in the appropriate cost or expense item, as part of the operating profit.
For companies in Mexico that prepare financial statements based on the International Financial Reporting Standards (IFRS), such as companies listed in the Mexican Stock Exchange Market, PTU would also constitute as an expense, since it is considered as an employee benefit which are all forms of consideration given by an entity in exchange for services rendered by employees and are registered for accounting purposes as an operating expense, when the entity consumes the economic benefit arising from the service provided by an employee in exchange for employee benefits.
While the PTU obligation increases the operating expenses of the operating entities, it is also important to consider the effect of the profit mark-up used to be charged by service providers to the operating entities in the controlled services transactions, which is then included by the operating entities as part of operating expenses.
The profit mark-up charges from the payment of services will no longer be paid by the operating entities (since no services transaction is being charged) or it will be considerably reduced (for groups that carry out services structures for ‘specialised services’).
There is no specific solution to the TP changes in the operating profit level indicator, since an increase or decrease of the operating profit for the operating entity may be obtained depending on the facts and circumstances of every specific case, which in general could be the following:
An operating entity whose payment of the profit mark-up for the service company was higher than the actual PTU charges to be carried out, would derive in an increase of its operating profit, and possibly a more beneficial TP profit level indicator; and
An operating entity whose payment of the profit mark-up for the service company was lower than the actual PTU charges to be carried out, deriving in a decrease of its operating profit, and possibly a more detrimental TP profit level indicator.
In accordance with the ITL, if upon an audit conducted by the tax authorities to the taxpayer (in this case, the operating entity) it is determined that the consideration for TP purposes does not lie within the arm’s-length range, it would be considered that the applicable TP consideration is the median of the arm’s-length range.
This is relevant, given that without performing any changes to TP policies by the entities of the group, the outsourcing reform and the transfer of employees between related parties it conveys, could have an impact on the operating profit of the operating entity and therefore adjust the profit level indicator used for TP purposes. This could be derived in the non-compliance with the arm’s-length interquartile range and further adjustments will be necessary.
To carry out this restructuring, interesting technical issues may arise in relation to the employer substitution scheme. For example, a consideration may be required in connection with the transfer of employees.
It should be noted that the outcome might likely change due to the specific characteristics and circumstances of the operating entity and the service company included in the restructuring, as well as the personnel involved.
In Mexico, TP provisions stated in the ITL do not encompass all the specific transactions carried out between related parties, as well as the specific analysis that should be carried out. However, Article 76, section XII of the ITL states that taxpayer entities, which undertake transactions with related parties, are required to determine their income and deductions considering the prices that would have been used in comparable transactions with or between independent parties.
OECD TP Guidelines
In addition, Article 179 establishes that for the interpretation of the provisions referring to TP issues, the ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’ (OECD TP Guidelines) will be applicable. If the OECD TP guidelines are modified, they could be employed, as long as they continue to be congruent with the provisions of the aforementioned law and the treaties celebrated by Mexico.
In connection with the transfer of employees, there are no specific provisions included in the ITL. Therefore, this item should be reviewed under the recommendations established in the OECD TP Guidelines, which are a source for interpretation in TP matters.
The OECD TP Guidelines analyse the transfer of employees in the ‘assembled workforce’ section, where they are defined as “successful assembling of a uniquely qualified or experienced cadre of employees”.
The existence of such an employee group may affect the arm’s-length price for services provided by the employee group or the efficiency with which services are provided or goods produced by the enterprise. Such factors should ordinarily be considered in a TP comparability analysis.
Companies should assess, based on a variety of factors, whether there is a need for a consideration derived from the transfer of the assembled workforce between related parties.
Likewise, considering the transfer of the workforce as a type of restructure, the OECD TP Guidelines, paragraph 9.16, states that “in order to determine whether the arm’s-length compensation should be payable upon a restructuring to any restructured entity within an MNE group and, if so, the amount of such compensation as well as the member of the group that should bear such compensation”.
It would be most important to accurately delineate the transactions occurring between the restructured entity and one or more other members of the group.
A review of the intercompany agreements would also be necessary to determine if the transfer of the personnel would derive in the payment of considerations from ‘termination clauses’ that could have been implemented.
Regarding the aforementioned, the OECD TP Guidelines, paragraph 1.154, states for the transfer of employees that “in many instances the transfer of individual employees between associated enterprises will not give rise to a need for compensation”.
Furthermore, as specific situations regarding the transfer of employees that could result in the transfer of a valuable know-how or other intangibles, which could require a compensation to be established are included in the OECD TP Guidelines, however these situations mention specific topics such as secret formulas being transferred with the employees or personnel who have the expertise to develop a startup company.
Given that the OECD TP Guidelines mentions that a compensation should only be required for certain scenarios such as where intangible assets are included in the transfer of employees, it should be understood that the restructuring through the transfer of employees so as to comply with the outsourcing reform, specifically regarding the transfer of personnel related with routine activities such as administrative or manufacturing services, should not derive in the need for compensation.
As an additional item, most service company structures were agreed based on a cost-plus compensation. This is all costs and expenses incurred by the service company, plus an arm’s-length profit mark-up.
As part of the basis for costs and expenses, the service companies included all hiring and training expenses required to provide the services to the operating entity. This is when the operating entity has already paid for the hiring and training of the personnel providing the services, including the addition of the arm’s-length profit mark-up.
If the related parties were to agree to a compensation for the transfer of employees, which is a restructuring carried out to comply with the outsourcing reform, this will mean that the operating entity will be paying twice to the service provider, since all hiring, training and all other expenses related with the personnel have already been paid though the service company structure fee.
It is also important to review the service entities standpoint, which considering the outsourcing reform are obliged to cancel all activities related to the provision of insourcing services to their related party operating entities.
The OECD TP Guidelines, paragraph 9.71, states that “not every case where a restructured entity experiences a reduction of its functions, assets and risks involves an actual loss of expected future profits. In some restructuring situations, the circumstances may be such that, rather than losing a ‘profit-making opportunity’, the restructured entity is actually being saved from the likelihood of a ‘loss-making opportunity’. An entity may agree to a restructuring as a better option than going out of business altogether”.
Derived from the outsourcing reform, the service entity would be legally disallowed to provide services to related parties (insourcing), therefore this business activity in Mexico will be terminated by a change in law. As a result, the service entities will have three options:
Continue to hire all personnel without being legally allowed of providing any services, this means all expenses related to labour activities will be assumed, however, no income will be received; Terminate personnel facing significant termination payments such as severance payments, among many others; and
Transfer personnel related to the provision of services to the operating entity, whereby all labour obligations and employee benefits will be assumed by the latter.
It is important to analyse whether third parties are involved in the service structure, this is by means of the operating entity receiving both outsourcing and insourcing services, or the service entity outsourcing certain activities from a third party.
In this case, the resolution to be achieved with the third party would be an arm’s-length approximation to be considered for the insourcing scheme. In general, it would be expected that even in the agreements with the third parties, the ceasing of the services transaction would be the only foreseeable resolution.
Given that the insourcing services are now disallowed by law, the restructuring to comply with the outsourcing reform, from a transfer of employees under the employer substitution scheme from the service company to the operating entity, in general, should not require the need for a compensation.
The recently approved outsourcing reform implies several relevant factors in different matters (labour, tax, TP, social security corporate) that have to be assessed for every specific case, in order to review possible liabilities and contingencies for taxpayers.
The author wishes to thank Roberto Borquez and Hector Steffani for their collaboration in the preparation of this article.
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Chevez Ruiz Zamarripa
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Ricardo Rendon is a partner at Chevez Ruiz Zamarripa. His main areas of specialisation are mergers and acquisitions, cross-border transactions, including TP.
Ricardo has also been heavily involved in unilateral and bilateral advance pricing agreements and alternative dispute resolutions.
Prior to Chevez Ruiz Zamarripa, Ricardo worked for a Big Four firm in the international tax department. He has a law degree from the Universidad del Valle de Mexico and he is also a CPA.