Changes in Mexico's Federal Labor Law
TAX ALERT |
On Dec. 1, 2012, important changes in Mexico’s Federal Labor Law (the 2012 amendments) came into effect. The amendments restrict, and in some cases eliminate, the benefits achieved through the use of an employment services company for purposes of minimizing an employer’s obligations under Mexican laws that mandate employee profit sharing benefits (known as PTU).
The 2012 Amendments contain multiple provisions related to procedure and administration in areas such as collective bargaining agreements and equal opportunity employment, among other things. This article focuses on the changes that affect planning structures designed to reduce PTU liability. Changes unrelated to PTU planning should be discussed with Mexican labor law specialists.
U.S. businesses will be affected by the 2012 amendments
U.S. enterprises that may be affected include, but are not limited to:
- U.S. business enterprises with operations in Mexico that, in addition to having an operating company to conduct business in Mexico, also have a staffing services company, as defined below
- U.S. business enterprises that hire employees in Mexico through the use of an outsourcing company
The 2012 amendments will affect any business enterprises that fall in the above categories, regardless of the activity carried out in Mexico (e.g., Maquiladora, distribution, manufacturing, construction, etc.)
In order to understand the impact of the 2012 amendments, one must first understand certain concepts, defined below.
Profit sharing (PTU)–Starting with the second year of operation, all Mexican companies, whether owned by domestic or foreign investors, that have employees are required by law to distribute PTU among their employees. The PTU equals 10 percent of the employer’s net taxable income (plus or minus certain adjustments), calculated without net operating losses from prior years. For example, assume a Mexican operating company (OpCo) that has employees, earns $1 million of net taxable income in calendar year 2012. The PTU would be as follows:
|Net taxable income||$1,000,000|
|PTU hypothetical adjustments||(100,000)|
|PTU (flat 10% rate)||$90,000|
In addition to the $90,000 in PTU, OpCo will also have to pay income tax of $300,000 (net taxable income of $1 million multiplied by the statutory flat rate of 30 percent).
PTU is mandatory, cannot be substituted by any discretionary bonus or incentive program the employer may have, and must be paid to the employees no later than May 15 of the following calendar year. The PTU is allocated to each employee following an allocation method established by the law (based primarily on salary level and number of days worked). The 2012 amendments do not affect the methods employers must use to allocate PTU.
Staffing services company (SSC)–In order to mitigate the financial burden of PTU, some companies establish a second Mexican legal entity (usually an affiliate of the existing operating company) that has all or most of the employees in its payroll. This second company, the staffing services company or SSC, leases out its employees to the operating company for a fee sufficient to allow the SSC to pay payroll and payroll taxes and still earn an arm’s-length profit. A commonly seen profit margin is 5 percent over and above payroll. Since the SSC (and not the operating company) is the employer of record, the PTU is based on the SSC’s net taxable income rather than on the operating company’s net taxable income.
For example, assume that the OpCo in the example set forth above uses an SSC to source its employees. If the SSC’s total cost of payroll during a calendar year is $600,000, the PTU that the SSC has to pay to the employees is determined as follows:
|Total cost of payroll||$600,000|
|Plus profit margin (total cost x 5%)||30,000|
|SSC fees charged to operating company||$630,000|
|SSC’s gross fee income for employee leasing||$630,000|
|SSC net taxable income||$30,000|
|Less PTU hypothetical adjustments||(2,000)|
|PTU (at a flat 10% rate)||$2,800|
In addition to the $2,800 in PTU, this SSC would also have to pay income tax of $9,000 (net taxable income of 30,000 multiplied by the statutory flat rate of 30 percent).
The savings in PTU from using an SSC are obvious ($90,000 vs. $2,800).While hypothetical, these numeric examples illustrate how an SSC can help achieve important savings in PTU.
Of note, using an SSC is not intended to deprive the employees from being rewarded for good performance. Rather, by reducing the mandatory PTU, the SSC allows companies to reward employees using their own terms.
Outsourcing company–Instead of setting up SSCs, some companies elect to hire the services of an actual third party outsourcing company. Oftentimes, this is done during the early stages of the commencement of operations, in cases where the operating company’s infrastructure is very simple, or where head count is so low that it is more efficient to simply engage the services of an outsourcing company to handle payroll. When a company uses the outsourcing company model, the PTU is based on the outsourcing company’s net taxable income and not on the operating company’s net taxable income.
“Look-through” provisions for SSCs
Prior to the 2012 amendments, SSC structures were widely used and accepted by Mexican tax and labor authorities along with workers’ organizations. There were very few occasions in which the government attempted to disallow these structures, and those situations typically involved a severe default by the SSC in meeting its employment-related obligations.
However, the 2012 amendments provide certain tests that, if met, will allow Mexican authorities to disregard an SSC as a separate legal entity. In this event, an operating company (not the SSC) will be deemed to be the employer. This may occur where:
- The SSC’s employees use tools, machinery, equipment and resources owned solely by the operating company
- The SSC does not provide a specialized technical service other than the leasing of employees
- The SSC’s employees work under instructions, supervision, policies, procedures, work hours and other employment-related rules dictated solely by the operating company
If any of the above tests are met, the PTU is calculated based on the combined net taxable income of the operating company and the SSC. Using the above example, the operating company would be liable for a PTU of $92,800 ($90,000 due by the operational company, plus $2,800 due by the SSC) if the SSC were disregarded under these rules
“Look-through” provisions for outsourcing companies
An operating business may be subject to these “look-through” rules even if it sources its employees from a third-party SSC. In this case, an operating company will be liable for PTU with respect to only the employees that work in its facilities under its instructions. However, because employees of a third-party outsourcing company may work for more than one operating company, it is less likely that the look-through tests will be satisfied. As a result, the exposure for operating companies that source their employees from unrelated employment companies may be lower than that of companies that use a related-party SSC.
In addition to managing its potential PTU obligations, an operating company that uses an outsourcing company has to ensure that the SSC meets all its employment-related obligations, such as the calculation, withholding and remittance of payroll taxes and social security taxes and the payment of mandatory benefits such as year-end bonuses, seniority premiums, severance payments, and retirement funds, among other things. Failure to do so will make the operating company liable for these employment-related obligations with respect to the employees that work in its facilities and under its instructions. Substantial monetary fines may also result from failure to meet these obligations. Based on current exchange rates and depending on the severity of the case, these fines can reach an estimated $12,000 per employee.
Transfer of employees with deliberate purpose
Companies that transfer employees from an SSC to multiple SSCs or to a third party with the deliberate purpose of avoiding meeting the tests may still be liable for the PTU owed to the transferred employees, as well as other employment-related obligations. These companies will also be subject to substantial monetary fines. At current exchange rates and depending on the severity of the case, the fines can reach an estimated $25,000 per employee.
No grandfathering rule relief
The changes in the new labor law do not provide grandfathering relief for existing structures. Therefore, the “look-through” rules previously discussed may apply to all SSC structures (third-party or related) existing before Dec. 1, 2012.
What can be done?
Unfortunately, very little can be done to avoid the look-through tests. However, where it is reasonably certain that the look-through rules will apply, companies should consider doing the following to minimize exposure to penalties under the 2012 amendments:
- For the calendar year ended Dec. 31, 2012, prepare a PTU provision based on combined operating company and SSC taxable income.
- In early 2013, consider transferring the employees of a related-party SSC to the operating company and liquidating the SSC. If properly executed, the transfer of employees should not trigger costly severance payments for the SSC or the loss of accumulated benefits for the employees. However, the liquidation of the SSC may become a costly and time-consuming endeavor, as Mexican laws impose several formal steps to totally terminate the SSC and the liquidation may trigger Mexican taxes.
- Alternatively, a related-party SSC may be merged into the operating company. If properly executed, the merger should not trigger costly severance payments for the SSC, the loss of accumulated benefits for the employees, or Mexican taxes.
- Companies that use the services of a third-party outsourcing company should analyze whether or not they meet the look-through tests and identify an appropriate course of action where appropriate.