New Regulations to the Mexican Income Tax Law Impact PE Exem

New Regulations to the Mexican Income Tax Law Impact PE Exemption Available to Foreign Residents with Maquiladora Operations in Mexico

Executive Summary

On December 4, 2006, new Regulations to the Mexican Income Tax Law (“MITL”) were published in Mexico´s Official Gazette. The new Regulations include a controversial provision (Article 4-A) which may limit the permanent establishment (“PE”) exemption available under Article 2 of the MITL to foreign residents operating with maquiladoras in Mexico. The effective date of Article 4-A is December 5, 2006.

In summary, Article 4-A intends to limit the aforementioned PE exemption to cases in which the foreign resident is resident of a jurisdiction whose Treaty with Mexico, or a Mutual Agreement, provides that the foreign resident´s activities in Mexico do not constitute a PE. The issuance of this Article came as a surprise to the maquiladora industry 1 considering that this provision limits tax benefits already granted by the MITL, creates legal uncertainty for the maquiladora and its related parties and threatens to increase the cost of operating manufacturing operations in Mexico. That is, considering the existing global competition for foreign investment in the manufacturing sector, it was surprising for Mexico to reverse a trend that had existed in the recent past to facilitate investment in the maquiladora industry by granting a tax credit to maquiladoras, codifying the PE exemption, and issuing clear transfer pricing guidance and taxpayer friendly VAT rules.

Discussion

Overview and History of Relevant Tax Aspects

Companies operating in the maquiladora industry typically operate under a consignment model. That is, the maquiladora does not own the inventories or M&E used in its operations; these assets are generally provided by the foreign related party on a consignment basis. Furthermore, the management personnel of the maquiladora will oftentimes be employed directly by the foreign residents.

The combination of these activities by the foreign resident in Mexico may create a Mexican PE exposure for the foreign resident. Notably, the PE exposure is greater in cases where the foreign resident is a US company considering that the US-Mexico Tax Treaty provides that a PE exists in the case that a maquiladora habitually processes on behalf of the US resident goods or merchandise maintained in Mexico by the US resident, provided that such processing is carried on using assets furnished, directly or indirectly, by the US resident.

Consequently, in an effort to attract foreign investment to the maquiladora industry, the PE exposure was mitigated through the issuance of a new provision to Article of the MITL as part of the 2003 Tax Reform. This provision (established in the penultimate paragraph of Article 2) explicitly provides that a foreign entity will not be deemed to create a PE for its activities related to a maquiladora program, provided that the foreign entity is resident in a country with which Mexico has entered into a tax treaty, that the maquiladora meets the transfer pricing requirements as established in Article 216-Bis of the MITL and that the foreign resident provides the inventory to be utilized by the maquiladora. Notably, the issuance of the penultimate paragraph to Article 2 was a result of efforts by the maquiladora industry to obtain legal certainty related to a potential PE exposure.

As part of the issuance of the penultimate paragraph to Article 2, a number of the tax benefits available to the maquiladora and its related party were tied back to this provision. That is, Article 216-Bis references the penultimate paragraph of Article 2. Consequently, only maquiladoras that fall under the requirements of Article 2 may be eligible to apply the transfer pricing options provided by Article 216-Bis. Furthermore, the Asset Tax exemption available to the related party of a maquiladora (provided in Article 2 section XIX of the 2003 Transitory Articles to the MITL) references Article 216-Bis. Hence, failure to meet the requirements of Article 2 could lead to an inability to apply Article 216-Bis and consequently, invalidate the Asset Tax exemption. Finally, the Presidential Decree tax credit also references the penultimate paragraph of Article 2. Thus, if the provisions of this paragraph are not applicable to the maquiladora, it may not be entitled to the benefits of the tax credit offered by the Presidential Decree issued on October 30, 2003. In sum, the right to apply the provisions of the penultimate paragraph of Article 2 are critically important to both the maquiladora and the related foreign resident.

Overview of Article 4-A

The new Article 4-A of the Regulations to the MITL provides that:

“For purposes of Article 2 of the MITL, the provision established in its penultimate paragraph shall only be applicable in the maquila contracts of foreign residents in countries with which the dispositions of tax treaties for the avoidance of double taxation and in the guidelines established in the Mutual Agreement Procedures celebrated by the competent authorities involved in the corresponding treaties, establish that foreign residents do not have a PE in Mexico for the maquila activities that Mexican residents perform”.

Based on the drafting of Article 4-A above, this new disposition provides that a PE exemption (and the related tax benefits mentioned above) is only available if the provisions of the tax treaties or Mutual Agreement Procedures (which only exists with the U.S.) establish that the foreign resident does not have a PE. On its face, it seems redundant for a PE exemption to be available only when a Treaty or Mutual Agreement Procedure already establishes that a PE does not exist.

Consequences of Article 4-A to Maquiladoras with US Related Parties

One way to read this new disposition is that the PE exemption is now limited to US investors since the Mutual Agreement Procedure between the competent authorities of the US and Mexico establishes that no PE shall be deemed to exist for the US related party of a maquila (if certain transfer pricing guidelines are met). Notably, the Mutual Agreement that was originally issued in 1999 (IR-INT-1999-13) applied for the 2000 through 2002 tax years. However, an addendum to the Mutual Agreement was issued in 2000 (IR-2000-56) which extends the Mutual Agreement indefinitely until either Competent Authority notifies the other of its intent to cancel this Agreement.

Notwithstanding the above, US companies may be affected by Article 4-A since the Mutual Agreement Procedure establishes that a PE would not be deemed to exist in Mexico for the U.S. investor to the extent the maquiladora complies with either the safe harbor transfer pricing option (the higher of 6.9% on assets or 6.5% on costs) or by obtaining an Advance Pricing Agreement (“APA”). As such, it could be interpreted that in cases where the investor is a U.S. resident, the PE exemption will only apply if the maquila meets the safe harbor threshold or has obtained an APA. Consequently, maquiladoras that apply options 1 or 3 of Article 216-Bis for purposes of transfer pricing compliance could subject their US related parties to a Mexican PE.

As such, due to the lack of certainty with respect to the scope of Article 4-A and the applicability of the Mutual Agreement with the U.S., it may be advisable to approach the Mexican tax authorities and request a confirmation of criteria with respect to the PE considerations for U.S. companies with maquiladoras in Mexico.

Consequences of Article 4-A to Maquiladoras with non-US Related Parties

With respect to non-U.S. companies with maquila operations in Mexico, Article 4-A provides that, in order to be eligible for the PE exemption of Article 2 of the MITL, the provisions of the applicable Tax Treaty should establish that the foreign resident does not have a PE for the maquiladora operations. Consequently, it appears that the threshold requirement for non-U.S. companies to be eligible for the PE exemption is more restrictive than for US companies. Notably, residents of jurisdictions that do not have a Treaty in force with Mexico do not qualify for the PE exemption of Article 2 and thus, Article 4-A has no impact to them.

For maquiladoras with non-US investment, a detailed analysis would need to be performed in order to evaluate whether a PE exists pursuant to the corresponding Tax Treaty based on the specific facts at hand.

As a final commentary on this topic, it is surprising that Mexico would choose to favor US investment in its efforts to compete for foreign investment for its manufacturing industry.

Legal Challenge – Is Article 4-A Unconstitutional?

From a legal standpoint, Article 4-A appears to go beyond the scope of Article 2 of the MITL since Article 4-A of the Regulations provides further requirements for eligibility to the PE exemption (i.e., that the Tax Treaty or mutual agreement exempt the manufacturing activities of the foreign resident from a having a PE in Mexico).

As such, in this situation, due the fact that, by law, the Regulations cannot override the MITL, the requirements established within Article 4-A may be deemed to be unconstitutional and thus, invalidate these requirements. Consequently, a possible alternative to protect oneself from the application of this new provision would be to file an injunction (“amparo”) before the Mexican courts challenging the constitutionality of Article 4-A. Notably, the Amparo would need to be filed within 30 business days from the effective date of Article 4-A; or within 15 days after the provisions of Article 4-A adversely impact the taxpayer (e.g., following an assessment by the Mexican tax authorities). Considering that both the maquiladora and the foreign resident may be adversely impacted by the provisions of Article 4-A, both parties may arguably need to file the Amparo.

Based on all of the above, it is clear that the lack of clarity in the scope and purpose of Article 4-A is raising important concerns for maquiladoras and their foreign related parties. As such, continued communication with the tax authorities and other government personnel will be critical in the upcoming months in order to achieve clarification on the applicability of this new article.