Deadline approaches for US companies with shelter maquiladora contracts
Mexico provides tax benefit extension to companies filing by Dec. 31, 2016
INSIGHT ARTICLE |
As part of the 2016 Miscellaneous Tax Rules Package, Mexico issued rules whereby U.S. companies that manufacture products through a contract with a shelter maquiladora can continue using such an arrangement for a period of up to eight years without triggering a permanent establishment in Mexico, provided they pay a certain amount of Mexican tax. We will refer to these rules as the “Shelter Rules”.
In order to apply the Shelter Rules, both the U.S. company and the shelter maquiladora have to make an election by Dec. 31, 2016 and meet certain Mexican filing requirements thereafter.
U.S. companies that use a shelter maquiladora should evaluate the impact that the Shelter Rules have on their Mexican and U.S. tax postures, and decide whether they should make the Dec. 31, 2016 election, or contemplate other courses of action.
To understand and evaluate the impact of the Shelter Rules, one must first understand certain concepts.
A considerable number of U.S. companies that carry out manufacturing or production processes in Mexico opt to set up and operate their own maquiladora (self-owned maquiladora). A self-owned maquiladora is a Mexican subsidiary wholly owned by a U.S. parent that provides contract manufacturing services exclusively to the U.S. parent or a U.S. related party thereof.
The self-owned maquiladora is required to charge a fee that meets the arm’s-length standard to the U.S. party for which it performs the services. Self-owned maquiladoras are not affected by the Shelter Rules, as they have their own exclusive tax treatment, which differs significantly from the tax rules governing Shelter Maquiladoras.
In contrast, a shelter maquiladora is a Mexican enterprise whose principal business activity is the rendering of contract manufacturing services to an array of customers, all of which are unrelated to the shelter maquiladora. A shelter maquiladora charges its’ customers fees in accordance with market prevailing rates.
Shelter maquiladoras - permanent establishment
Under the provisions of the Mexican Income Tax Law and the U.S.-Mexico Income Tax Treaty (the Treaty), under certain circumstances, a U.S. company that has a contract with a shelter maquiladora will have a permanent establishment in Mexico with respect to the manufacturing operations that shelter maquiladora performs for the U.S. company.
Having a permanent establishment in Mexico will subject the U.S. company to Mexican taxes on all or a portion of the revenue that the U.S. company obtains from the sale of products manufactured by the shelter maquiladora, even if those products are sold outside Mexico. Appropriate costs and expenses (determined under Mexican tax principles) can be deducted from gross revenue in order to determine net taxable income, which is then taxed at a flat 30 percent rate.
The portion of the revenue subject to Mexican permanent establishment taxation will typically be directly related to the contribution of the shelter maquiladora to the entire production process. The following examples illustrate how this works:
U.S. Company A has a contract with Shelter Maquiladora A to manufacture shoes in Mexico. Accordingly, Shelter Maquiladora A imports into Mexico all the materials (hide, rubber, soles, laces, and adhesives) and assembles the shoe. The process performed by Shelter Maquiladora A encompasses the entire assembly of the shoes, from the cutting of the leather hides through the packaging of the finished pairs of shoes in boxes, and shipment back to the United States. If U.S. Company A had a permanent establishment in Mexico due to Shelter Maquiladora A’s manufacturing operations, very likely 100 percent of the revenue made by U.S. Company A will be subject to taxation in Mexico, given Shelter Maquiladora A’s extensive contribution to the production process.
U.S. Company B, a competitor of U.S. Company A, has a contract with Shelter Maquiladora B to sort and package pairs of shoes. Accordingly, Shelter Maquiladora B imports into Mexico the boxes, packaging materials and fully finished shoes. Shelter Maquiladora B sorts the shoes by style and size, puts them in the appropriate boxes and ships them back to the U.S. If U.S. Company B had a permanent establishment in Mexico due to Shelter Maquiladora B’s sorting and packaging operations, it is likely that only a relatively small portion of the revenue obtained thereof will be subject to taxation in Mexico, since Shelter Maquiladora B’s contribution to the manufacturing process was limited to sorting and packaging fully finished shoes.
Generally, the United States will allow the U.S. company to credit the tax the company pays to Mexico against its U.S. income tax. However, the ability to take a foreign tax credit should be analyzed on a case by case basis given the significant statutory limitations on the credit imposed by U.S. Internal Revenue Code provisions.
Shelter maquiladoras – Impact of the 2014 Tax Reform
As discussed in our white paper related to the Mexican 2014 Tax Reform, U.S. companies that operate in Mexico through a shelter maquiladora will not be subject to permanent establishment taxation in Mexico for a period of four tax years beginning in the year in which they commence manufacturing operations with the shelter maquiladora, provided that the shelter maquiladora meets all its Mexican filing requirements. After the four year period, U.S. companies utilizing a shelter maquiladora will automatically be considered to have a permanent establishment in Mexico, resulting in the tax consequences discussed above.
The following chart illustrates this:
Date contract with shelter maquiladora is signed
Date four-year protection period expires
On or before 12/31/2013
At any time during 2014
At any time during 2015
At any time during 2016
Prior to the publication of the Shelter Rules, U.S. companies that faced permanent establishment taxation could opt to set up a self-owned maquiladora, or relocate the manufacturing operations outside Mexico.
Effects of the Shelter Rules
The Shelter Rules provide an extension to the four-year period provided by the 2014 Tax Reform, and is applicable to the extent the Treaty remains in force. The following are the principal requirements that both electing U.S. companies and shelter maquiladoras must satisfy in order to elect the four-year extension:
- The shelter maquiladora must file, on behalf of each of the electing U.S. companies, an election to extend the four-year period. This election must be made by Dec. 31, 2016 and to date, no extensions to the filing due date have been announced.
- The U.S. company must obtain a special Federal Tax Identification Number (RFC) with the Mexican tax authorities (SAT).
- The shelter company must pay, on behalf of the U.S. company, an amount of Mexican tax, the basis of which must be calculated under the Safe Harbor Rules for the duration of the extended four year period that follows the original, expired four year period. The shelter company must pay this tax on behalf of each electing U.S. company. The shelter company must make monthly estimated pre-payments on behalf of its electing U.S. companies, with an annual return showing an annual tax return filed by March 31 of the following year. In order for the shelter company to make these payments, each of the electing U.S. companies must provide the necessary funds.
Under the Safe Harbor Rules, the base amount subject to tax is the greater of :
An amount equal to 6.5 percent of the total costs and expenses incurred by the shelter maquiladora in the performance of its manufacturing operations (payroll, utilities, consumables, rent, among other),
An amount equal to 6.9 percent of the net value calculated under Mexican tax principles of all assets employed by the shelter maquiladora in the manufacturing operations, whether owned by the U.S. company or by the shelter maquiladora (cash, materials, machinery, equipment, tools, among other)
This amount is taxed at a flat 30 percent rate
- The shelter maquiladora must accept joint liability with respect to the above tax. By accepting this joint liability, the SAT will conduct any audit proceedings with respect to this tax with the shelter maquiladora, and not with the electing U.S. companies.
- The shelter maquiladora must maintain a set of separate records and documentation per each U.S. electing company on behalf of which it pays the tax, in compliance with Mexico’s statute of limitations, which is generally six years.
- A professional firm that is part of an international network must certify the basis determined for each of the electing U.S. companies. The Shelter Rules are silent as to the definition of the term “firm.” However it is reasonable to interpret that the provision refers to an accounting firm, given the nature of the certification.
- The shelter maquiladora must provide a form to each of the electing U.S. companies showing the amount of tax paid on behalf of the latter. The electing U.S. companies can use this form as proof of payment of a foreign tax for U.S. foreign tax credit purposes.
- The shelter maquiladora must meet its multiple information filing requirements.
- The shelter maquiladora must be current with all its applicable tax filings as an enterprise taxpayer.
Failure to meet any of the above requirements will cause the revocation of the extended four year protection period. The Shelter Rules, however, provide an opportunity for an electing U.S. company to terminate the contract with an offending shelter maquiladora and sign a contract with a new shelter maquiladora without losing the protection of the extended four-year period.
What should U.S. companies do?
Given the impending Dec. 31, 2016 deadline to make the election, U.S. companies that currently have a contract with a shelter maquiladora must evaluate whether they should elect the four-year extension period, especially in light of the fact that they will have to pay a tax (the tax based on the Safe-Harbor Rules) during that period of time. Tax considerations that a U.S. company should take into account include, among other, the following:
- The extent of the potential Mexican income tax liability in the event of a permanent establishment, based on the contribution by the shelter maquiladora to the entire manufacturing process (see Examples A and B above)
- The amount of tax determined under the Safe Harbor Rules that may result if the U.S. Company taxpayer elects the four-year extension
- The impact that a potential election may have on the cost of using a shelter maquiladora, in terms of potential adjustments to the contractor fees that the shelter maquiladora intends to make
- Their U.S. foreign tax credit position
- The advantages and disadvantages of setting up their self-owned maquiladora by the time the original four-year period expires.
There are also multiple non-tax factors (such as impact on logistics, vendor and customer relationships, among other) that need to be taken into consideration.