On November 12 2020, the President presented to Congress an initiative to reform different labour and tax provisions with regard to the subcontracting of labour.
As a background, this has been a controversial matter, as it has been very common for companies to separate employees from the main business entity by creating a labour service company looking to:
(i) Streamline internal operating and administrative processes;
(ii) Segregate labour risks, and protect assets and operations; and
(iii) Control the economic impact of a 10% profit sharing obligation.
This has been done by using a third-party company that hires the employees and provides the manpower services to the operating company (i.e. outsourcing companies) or by setting up an intra-group company to house the employees and provide the manpower services (i.e. insourcing companies).
Sadly, the use of outsourcing companies has proliferated for very aggressive planning (for labour, tax and social security purposes) or even falling into tax fraud situations. As a result, the Mexican government has been clear on its intention to eliminate the use of these ‘bad’ outsourcing structures and hinder the negative effects that this carries in tax collection, labour relationships and social security, among others; and rightfully so.
Consequently, there have been different attempts to reform Mexican legislation to tackle these structures from a labour and tax perspective such as the:
(i) 2012 labour reform defined and regulated subcontracting structures, establishing situations to create a labour relationship;
(ii) 2017 tax reform obligated the recipient of the services to have all documentary evidence related to the service provider’s tax and social security obligations; and
(iii) 2020 tax reform obligated the recipients of services provided to withhold VAT at 6%.
The new initiative
An initiative was presented into Congress which prohibits the rendering of ‘subcontracting of personnel’, defined as those where employees are provided or made available in benefit of another. The initiative also establishes rules for companies that hire ‘specialised services’ or the ‘execution of specialised work’, that are not related to their main business purpose or their economic activity.
The bill would eliminate all articles related to subcontracting, while allowing for specialised services or the execution of specialised work that are not part of the beneficiary’s business purpose to be conducted with prior authorisation from the Ministry of Labour.
The initiative then contains reforms to social security and housing fund laws to provide a comprehensive legal framework dealing with the implications and effects in the other subject matters as a result of the new labour regulation. Below, there is a focus on the Mexican tax implications and considerations related to this initiative.
While the existing VAT withholding obligation (6%) would be repealed, the Federal Tax Code would be amended to specifically establish that taxpayers will not be allowed to claim the deduction or the VAT credit on payments for the subcontracting of personnel, or for those where personnel is provided or made available (which were previously transferred by the recipient or if the services cover the recipient’s main activities). They may, however, consider payments for specialised services provided that they obtain significant documentation from the service provider.
Furthermore, joint liability would be attributed to those companies that receive the subcontracting services with regard to the taxes levied on the employees of the service provider. There are penalties for those that do not comply with all applicable obligations, and the use of simulated schemes of the rendering of specialised services or execution of specialised work, as well as subcontracting of personnel, will be treated as a criminal offense.
Concerns for companies in Mexico
Should it be approved as proposed, the tax portion of the reform would be effective January 1 2021 and would negatively impact companies in Mexico. This is in consideration of profit-sharing and other labour-related matters, with potential non-deductible expenses and the disallowance of VAT credit.
Additionally, there is the possibility of criminal charges, while it could also leave a lot of loose ends and unclarity as to specific situations. The following are concerns are from the initial analysis made of the proposals:
The definition of ‘subcontracting of personnel’ is based on employees being provided or made available to the recipient, without clarifying when that should be the case. In addition to the difficulties to identify when that is the case, the initial reading proves that commonly used ‘intra-group’ service companies would no longer be permitted.
The existing 6% VAT withholding is based on similar wording and has already led to much controversy (‘making available’) and a lot of companies in Mexico have thought that in the case of doubt, a conservative position is to withhold the VAT, which could be taken as a sign of acceptance of the existence of such situation for purposes of these new provisions.
The existence of specialised services is also unclear, and it could refer to those where the workers are provided or made available to the recipient, or to any type of service. The latter interpretation could lead to basically any service having to be authorised, which would be absurd.
Subcontracting structures are currently legal, therefore, making them illegal puts Mexican companies in a contradicting situation and jeopardises legal certainty and continuity principles and the extremely short period to comply would be absurd.
Reforms to Federal Tax Code are very extreme and could lead to retroactive effects when referring to employees being transferred; particularly, without clarity if it refers to employees having been transferred starting 2021 or before.
This will force corporate groups to evaluate the cost of doing business in Mexico, considering increased profit sharing and potentially discouraging investment, unless it is paired with a logical reduction (10% rate comes from periods of ‘hyperinflation’). If profit sharing is the intention, the inclusion of a ‘business unit’ concept could be considered.
In addition, having the employees in one operating entity may not be feasible or at best, more expensive, for different business lines or from an internal process perspective. This is the reason for which shared service centres are common.
Although the need to hinder the use of aggressive outsourcing schemes is welcome, the reform would be too broad, affecting other structures that are not placed with aggressive tax-planning purposes and other true third-party services (at best, with extremely complex compliance, similar to what has already been tried once and failed), and current economic environment should lead to attract investment and create jobs.
It can be strongly urged that all companies doing business in Mexico immediately identify not only their labour and tax structure, but also all other services received from third parties in order to properly assess their situation and evaluate the best course of action.
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