On Apr. 23, 2021, the Mexican Congress passed legislation originally proposed by President López Obrador that effectively prohibits the subcontracting of personnel in certain abusive arrangements.
In recent years, the Mexican government has undertaken initiatives to deter abusive subcontracting arrangements where full-time personnel are employed by an affiliate or a third-party company, often depriving workers from some benefits and fundamental protections such as profit sharing, retirement and healthcare benefits. This includes a commonly used two-entity structure many Mexican companies have used for several years.
The legislation passed by Congress on April 23 included changes to different pieces of legislation (employment, social security, and tax law) that in total are designed to ban the use of subcontracting arrangements. In addition to severe tax ramifications, penalties and fines, offending taxpayers may face judicial consequences, as this type of arrangements are now legally prohibited. Offending companies need to take action by July 23, 2021.
Some companies operating in Mexico set up separate firms to employ most of their workers as a way of avoiding legal and tax burdens including a mandatory annual profit sharing payment to employees. A typical structure might involve:
- One entity performing the main business activity (OpCo)
- A second legal entity acting as an “insourcing” staffing company for the OpCo (Staffing Co)
Thus, the Staffing Co has all or most of the employees in its payroll, and charges a staffing fee to the OpCo, usually based on a mark-up over and above the salaries, wages and other related costs of the staff use by the OpCo. The Staffing Co is the employer of record and therefore, is responsible for withholding and remitting payroll taxes, and for meeting all labor-related obligations, including mandatory fringe benefits and mandatory employees’ profit sharing. The Staffing Co is also liable for any labor-related disputes and liabilities.
In many instances, the two-entity structure outlined above provides certain profit sharing savings, and helps protect the OpCo and its assets from potential labor liabilities. However, the structure has also been abused by certain companies to reduce or even eliminate payroll and social security taxes. In some extreme cases of abuse involving third party staffing companies, certain structures deprived workers of some fundamental protections, such as retirement and healthcare benefits among other things.
Over the past decades, the Mexican government has undertaken initiatives to deter these abusive payroll sub-contracting arrangements, with limited success. In response, in November 2020, Mexico’s President López Obrador signed a decree proposing important changes to various pieces of legislation designed to combat these arrangements.
After months of speculation on April 23, 2021, the Mexican Congress finally passed legislation, which does not differ significantly from the proposal of President López Obrador’s November 2020 decree.
In summary, the legislation is designed to prohibit sub-contracting arrangements, even where a third-party is used to attain similar benefits as the ones mentioned above. Unfortunately, these measures may also apply to companies that use the two-entity structure to separate functions, liability and to achieve certain legitimate tax savings. Taxpayers using a two-entity must be aware of the legislation, as it will have a significant effect on their Mexican operations.
Summary of the legislation
The summary below captures the most important measures included in the legislation:
Unless otherwise specified, the Legislation is applicable effective Apr. 25, 2021.
Employee profit sharing (PTU)
For context, PTU is a mandatory benefit employers must distribute among their employees. The total amount of distributable PTU equals 10% of the employer’s net taxable income (plus or minus certain adjustments), calculated without net operating losses from prior years. This remains unchanged by the legislation.
For years ending before or on Dec. 31, 2020, the amount each employee receives is based on his or her days worked during the year, as well as their pay rate as of the end of the year.
Under the new legislation, for years ending on or after Dec. 31, 2021, PTU that each employee receives is the higher of either of these two amounts:
- three months of the employee’s current salary, or
- the average PTU that the worker received for each of the prior three years.
The aggregate amount of PTU that the employer has to distribute under this new methodology cannot exceed the distributable PTU (calculated as 10% of the net taxable income).
This new methodology will require employers to update their ERP and payroll applications to properly determine the amount of PTU each employee is entitled to receive. It will also require that companies rethink their PTU accrual and budget policies.
Federal labor law
The legislation introduces the concept of employment subcontracting. Employment subcontracting exists when a natural or legal person hires employees under its payroll, with the sole purpose of having those employees work at the premises and under the instructions and policies of another natural or legal person, and those employees perform activities that are fundamental to the other person’s main business activity. Employment subcontracting is expressly forbidden under the federal labor law.
The use of a true independent contractor or outsourcing services firm, the employees of which perform certain specific tasks or specialized services, is still allowed, so long as these activities are not part of the main business purpose of the enterprise.
Not much guidance is provided with respect to the scope of the terms specific tasks or specialized services. However, RSM is of the view that these terms encompass “shared services” arrangements commonly used in multinational groups, where a legal entity has the appropriate employees to perform centralized, back office functions for an affiliated group of companies, such as financial reporting, governance, tax and regulatory compliance, recruiting, marketing, among other things. It is not clear whether additional guidance will be published to elaborate on the aforementioned concepts.
Companies that perform specific tasks or specialized services are required to obtain a registration as such from Mexico’s Secretary of Labor. The registration is renewable every three years. According to the legislation, the rules to apply for the registration will be published by no later than May 23, 2021. Once the rules are published, these companies will have ninety days to apply for the registration.
A written contract detailing the terms and conditions of the services must be signed by officers of both the specialized services company and the recipient of the services. This holds true whether they are related or unrelated parties.
Employment agencies involved in the hiring process may still participate in recruitment, selection, and training activities.
Tax procedural matters
The concept of employment subcontracting stipulated for labor law purposes, also applies for all tax intents.
Mexican companies using non-compliant or abusive employment subcontracting structures will be subject to substantial tax penalties and fines, and more importantly, may also face tax evasion charges. They may also be held jointly liable for any payroll and social security contributions that the employer of record fails to pay.
The consequences outlined above will also apply to Mexican companies that use employment subcontracting structures disguised as a “true” independent contractor.
The above tax procedural concepts will become applicable Aug. 1, 2021.
Mexican companies that use non-compliant or abusive employment subcontracting structures, or employment subcontracting structures disguised as an independent contractor arrangements, will not be able to claim a deduction for the fees they pay in exchange for the services.
In order for a Mexican company to claim the deduction of fees paid to a registered provider of specialized services or specific tasks, it must obtain a copy of the latter’s license issued by the Secretary of Labor, and confirm that it remits the appropriate payroll and social security taxes. This will apply to shared services arrangements.
These income tax-related provisions will become applicable Aug. 1, 2021.
Mexican companies using non-compliant or abusive employment subcontracting structures, or employment subcontracting structures disguised as a true independent contractor arrangements, will not be able to claim an output credit of the related VAT.
In order for a Mexican company to claim an output credit of the VAT paid to a registered provider of specialized services or specific tasks, it must obtain a copy of the latter’s license issued by the Secretary of Labor, and confirm that it remits the appropriate payroll and social security taxes. This also applies to shared services arrangements.
These value-added tax-related provisions will become applicable Aug. 1, 2021.
Social security taxes and housing fund contributions
Registered specialized services companies must file a quarterly report with the competent authorities (Mexico’s Social Security Administration and National Housing Fund Administration) containing information on the services contracts they sign, disclosing the identity of the customers with whom they sign services contracts, along with other pertinent information.
Transition mechanisms and important dates to consider
Companies that find themselves in a “bad” sub-contracting structure must complete remedial actions no later than July 23, 2021. These remedial actions include transferring the appropriate employees and assets to the operating company. Companies are given the opportunity to complete the transfer of assets at a later date, if by July 23, 2021 they at least complete the transfer of the employees. An attorney specialized in Mexican labor laws and procedures should handle the process and paperwork needed to effect the transfer of employees.
WHAT SHOULD COMPANIES DO NOW?
A number of U.S. companies with operations in Mexico outsourcing personnel or that have operated under the two-entity structure will likely find themselves in default of the legislation. These companies should evaluate, with the help of their tax advisors and legal counsel, how they may be affected, and what potential courses of action exist.
Most likely, affected companies will have to reorganize their Mexican operations following two steps:
- Effect the transfer of employees from the subcontracting company to the operating company, by July 23, 2021. Companies that have more than one operating entity will have to strategize how to re-assign each employee to the appropriate operating company.
- Plan an efficient way to transfer any assets from the subcontracting company to the operating company. Most transfers of assets will result in Mexican tax consequences, such as capital gains for the transferor, and value-added tax for the transferee; in some instances, a merger of the subcontracting company into the operating company may be the most tax-efficient solution, since a properly-executed merger can be a non-taxable reorganization under Mexican tax law.
Of course, foreign owners of these structures should also evaluate the tax consequences that a transfer of assets or a merger may have in their own tax jurisdictions.
In addition, foreign companies hiring personnel in Mexico through an outsourcing company should also exercise caution to avoid facing considerable consequences of the legislation. In some instances (for example, where the foreign company has a permanent establishment in Mexico by virtue of having representatives in Mexico performing certain activities), said foreign company may be considered employer under Mexican labor law and accordingly, may find itself in a bad sub-contracting structure. As a best practice, foreign companies should ensure that the outsourcing company they hire in Mexico is a registered provider of specialized services or specific tasks.
If you have specific questions about how any of these rules may impact your business, please contact us today. We are here to help.