Tecma Group of Companies:

Welcome to another podcast recorded by the Tecma Group of Companies on issues that have to do with manufacturing in Mexico. Today we are examining a topic has to do with subject that is very very important to the maquladora industry. Today we have with us somebody from the international law firm Baker & McKenzie. Baker & McKenzie is a large law firm that is involved in many areas, the maquladora industry in Mexico being one of them. Luis Carbajo, who is a tax principal for the company, will explain what he does with Baker & McKenzie, and a little bit about the firm to begin with.

Luis Carbajo:

Thank you very much. Good morning everyone. Thanks for having me here.

Tecma Group of Companies:

Luis, could you tell us a bit about yourself, and your company, as well as something about the responsibilities that you carry out within the firm.

Luis Carbajo:

As you may know, Baker & McKenzie is a law firm. We provide all kinds of legal services, not only for maquiladoras, but for most of the multi-nationals doing business in-bound into Mexico. We have a strong practice servicing the maquiladora needs out of our Tijuana and Juarez offices, as well as tax advising and processing capabilities in the Monterrey office. Also, we provide a wide range of other types of legal services in Mexico, not only to maquiladoras, but to other companies such as those in the oil and gas industry, textile manufacturing and service companies. We provide specifically, in the tax arena, not only legal services, but others such as accounting, financial services, i.e., any thing that any other services that a firm like ours would render, except for the auditing of financial statements.

Tecma Group of Companies:

Thank you for that overview of the services that Baker & McKenzie offers to its clients in Mexico. Today we are going to discuss something that has been very very prominent on the radar of companies that are manufacturing in Mexico at present, or thinking of doing so in the future. This has to do with the Mexican tax reform proposal that was submitted during the month of October by President Enrique Pena Nieto to the Mexican House of Representatives. It was passed there and was passed up to the Mexican Senate.

There are some things that have happened in its regard that are definitive at this point. Of course, you are going to give us precise information, but can you provide us some background on the issue?

Luis Carbajo:

Yes. As you may know, during the last year, when president Enrique Pena Nieto took over the Executive Branch of the Mexican government he received several proposals from the OECD, the Organization for Economic Co-operation and Development. Mexico is chairing the OECD, at present, in Paris. Mexico’s former finance minister Angel Gurria, is now Secretary General of the OECD.

The OECD drafted several recommendations for Mexico regarding the necessity to increase revenue so that the country would not depend so greatly on oil and gas revenue from Pemex. The recommendations were widely publicized, not only in specific tax publications, but also in the media. Basically, for maquiladoras, the recommendation was to review and revise all the tax incentives and privileges enjoyed by the maquiladora in the past years. That is one of the reasons that the Executive Branch started to draft specific tax reform proposals aiming to eliminate many of the tax incentives and exemptions that the maquiladora industry has enjoyed in the past. That is pretty much the background on this. The specific provisions were dramatic, if you will, for the maquiladora sector because if the original proposal had been enacted, it would have caused harm to the maquiladora industry as such.

Tecma Group of Companies:

Over the course of the next few minutes, we are going to get to the information as to where we stand today. Obviously, Mexican tax reform legislation has been passed, but it has been diluted. To begin, if the Reform had enacted as was originally proposed, what kind of impact do you think that it would have had on Mexico’s maquiladora industry’s ability to attract capital investment?

Luis Carbajo:

We have had the opportunity to review the specific reform for maquiladoras. It creates a little more certainty, if you will, but the Mexican tax reform by itself eliminates many of the incentives and advantages that maquiladoras used to have. It is important here to pause, and to examine the scope of the Mexican tax reform for the maquiladoras, because “maquiladora” is a term that perhaps, for many of our listeners, would not have the right connotation.

If I may, I would like to clarify what the impact is for maquiladoras, but to some of the maquiladoras that are in the industry. Not all maquiladoras would have enjoyed earlier tax benefits and, therefore, this piece of legislation would not have any dramatic consequences for these types of operations.

If I may, just to clarify, a maquiladora operation basically is one has as a non-resident company, or multi-national, someone in Mexico who is your dependent agent, if you will. It is a subsidiary of a foreign company. It is a Mexican company organized, and existing under Mexican laws that has a specific program that is secured from the Ministry of Economy, and that program allows to import into Mexico goods and components on a temporary basis. The company would not have to pay any VAT (value-added-tax) at this moment. Although this issue is a part of the changes, payment of the VAT on temporary importations is not required.

Tecma Group of Companies:

May I interrupt for a moment? Could you please explain what the VAT or the value-added-tax in Mexico is for our listeners? Some may not be familiar with the term and concept, because we do not have this in the United States.

Luis Carbajo:

VAT in Mexico is a specific tax on consumption. If you are importing into Mexico, if you are selling in Mexico, if you are renting in Mexico, or if you are rendering services in Mexico, all these activities are subject to the VAT. Companies can credit the VAT in Mexico throughout the productive process, but at the end of the process the VAT is passed along to purchasers as a tax on consumption, that is the final consumer.

Tecma Group of Companies:

The Mexican tax reform was aimed at changing the relationship of the value-added-tax to the maquiladora industry?

Luis Carbajo:

Yes. This is one of the basic changes. There are other very important modifications in the maquiladora arena that would not pertain to value-added-tax, but would include corporate income tax in the maquiladora industry.

Tecma Group of Companies:

If you could explain those two points (changes in the value-added-tax and the income tax) we would appreciate that. Those are the major points, correct?

Luis Carbajo:

Yes, but basically, again, we have several definitions of maquiladora operations in Mexico. One definition is a situation where a company imports inputs, does not have to pay duties or have to comply with many Mexican Customs requirements. That’s one definition. Then we have another definition for the VAT, for value-added-tax purposes. Basically, if you are rendering services under your maquiladora program, if you are exporting those services, a zero percent rate would be applied. There is no additional cost that would be borne by the client or purchaser in the United States.

These two benefits are not gone. They will remain in place and were not a part of the Mexican tax reform discussions in Mexico. What is happening here is that there are other types of maquiladoras that are Mexican companies that that have their programs. The whole purpose of these maquiladora operations in Mexico is to bring machinery and equipment into the country on a temporary basis. Additionally, to bring into the country inventory to be transformed, re manufactured or assembled with the machinery and equipment of the non-resident principal, and, perhaps, to have several employees of the non-resident principal directing the day-to-day operations of the Mexican maquiladora. These expats would be the ones directing the company, deciding who to hire and fire, when to use the machinery and equipment, and to direct the production.

Mexico is looking at this as a business cycle. Everything is being done in Mexico, and, therefore, Mexico should be able to tax the sales transaction, the sale that takes place once the maquiladora exports the finished products and the non-resident principal makes that sale abroad. That is what Mexico is trying to do based upon a tax concept called “permanent establishment.” Basically, the maquiladora would create a permanent establishment, which is a taxable presence for the non-resident principal, again, because the maquiladora would be a dependent agent of the principal. It would have machinery and equipment of the principal and with that machinery and equipment it would be manufacturing, or assembling, or providing transformation services at the end of the day of this machinery and equipment with the assets kept in Mexico. The sole purpose of the activity is to export one hundred percent of the production back to the U.S., or other countries abroad. This creates permanent establishment exposure. For many years this permanent establishment exposure has been a headache for multi-nationals. This is because, Mexico, like many other countries, doesn’t have clear rules as to what income is to be attributable to the permanent establishment. Therefore, many years ago, the maquiladora sector reached an agreement with the Mexican tax administration in order to avoid, to have the non-resident principal not to have a permanent establishment in Mexico in exchange for the maquiladora in order to comply with transfer pricing under certain specific thresholds.

The first big change in the industry is that now whatever special treatments that the maquiladoras would have would be aimed specifically at maquiladoras that may create the permanent establishment exposure for non-resident principals. What does that mean? Well, basically, maquiladoras that would have machinery and equipment of the non-resident principal, inventory of the non-resident principal and transformations services that would be undertaken with the machinery and equipment of the non-resident principal with the sole purpose of exporting one hundred percent of the production outside of Mexico.

One of the original proposals was that one hundred percent of the production of the maquiladora would have to be physically sent outside of Mexico. With the negotiations, it was possible to reach a consensus in the sense that maquiladoras can now use so-called “virtual operations,” or “virtual manifests. In this specific case, the maquiladoras do not have to send the product physically out of Mexico. They are making virtual filings of Customs manifests, and this will continue to be the case for the next year. This is one of the achievements of negotiations by the industry. Otherwise, imagine that a maquiladora is located in San Luis Potosi, for instance, that wants to send finished product to a maquiladora in Mexico City, because it is a semi-finished product. In order to qualify for beneficial Mexican tax treatment, the maquiladora in San Luis Potosi would have to send one hundred percent of the production to the border, and then the Mexico City maquiladora would have to import the semi-finished product back into Mexico, dealing with all the logistics and other issues that would be required.

The first big change is that maquiladoras will be able to utilize virtual import and export manifests in order to comply with the definition of a maquiladora operation for the purpose of avoiding the creation of permanent establishment exposure for non-resident principals.

Tecma Group of Companies:

This was one of the things that, if passed as originally written, the Mexican tax reform would have required exportation and re-importation of goods to get the preferential tax treatment. Would that be correct?

Luis Carbajo:

Yes. Exactly. The negotiation of this point is one of the achievements of a group called Index, which represents that maquiladora industry throughout the Mexican Republic. Index had a lot of meetings to lobby, not only the Executive Branch, but also members of Mexico’s Congress. At these meetings, many people involved in the maquiladora sector had their voices heard in order to express their fears of the harm that this legislation would have created if virtual import and export manifests would no longer be available for maquiladoras for the purpose of complying with their income tax obligations, and not to create permanent establishment exposure for non-resident principals

Tecma Group of Companies:

For those that are new to this topic, Index is an acronym. Essentially the organization is a group that represents those interests involved in the maquiladora industry. They lobby against policy that they feel is detrimental to the industry. The aforementioned not being enacted is largely due to the efforts of this group’s interaction with the Mexican government and lawmakers. Would that be correct?

Luis Carbajo:

It was mainly Index that conducted the negotiations, but we are aware of other organizations and companies that did their homework on the Mexican tax reform. They had their own meetings with congressmen, and with the Executive Branch on an individual basis. Those companies would possibly also have been a part of Index’s tax committee. At the end of the day, it was a joint effort. There were very many maquiladoras that were worried about these modifications in the law.

Tecma Group of Companies:

Given the fact that the first provision had to do with the value-added-tax, as you mentioned, then need to pay value-added-tax on imports incorporated into products that would be ultimately exported would have tied up I would assume. There would have been a significant financial cost attached to it. This is something, that again, has been put on the shelf until January of 2015.

What about the income tax changes that were contemplated by this reform? Could you tell us what happened with respect to them?

Luis Carbajo:

The new maquiladora provisions substantially eliminate all the income tax benefits that maquiladoras were enjoying for the last several years. Right now, we have three federal taxes: we have income tax; we have flat tax, which is called IETU, it’s a Mexican acronym; and, also, we have the value-added-tax. We have already discussed the Mexican value-added-tax. Basically, again, taxing temporary importations with the VAT will be postponed. We will discuss later on certain mechanism to ensure crediting of the VAT to be paid on the temporary importations as a result of certain certifications. We are not clear as to what this would encompass at this point, but, from an income and a flat tax perspective, the maquiladoras enjoyed a tax holiday, or certain tax incentives, under the Fox and Calderon administrations, two former presidents of Mexico, when an overall tax of 17.5% was paid with deductions. Why am I saying deductions? Well, because the IETU, or the flat tax, which would be repealed, by the way, effective next year. Under the flat tax, which was like an alternative minimum tax, taxpayers, aside from the maquiladoras, would have to compute the income tax and the flat tax (on a cash basis, with no deductions). So, basically, the flat tax was like an alternative minimum tax. If you have higher income tax than the flat tax, the flat tax would be completely offset. If the flat tax is higher than the income tax, then you would pay income tax and the difference would be flat tax. This was not the case for maquiladoras. Maquiladoras would pay only 17.5% on a combined basis with deductions. This specific rate will be gone next year. Maquiladoras will have to pay thirty percent on a net basis. This specific modification, by itself, represents a big hit to the maquiladora industry because now it would be more expensive to manufacture goods and components in Mexico. Maquiladoras will no longer be taxed at the 17.5% rate that they enjoyed before the Mexican tax reform. This is the most important issue for maquiladoras from an income tax perspective.

There are others. For instance, this is not only for maquiladoras, but, also, for any other type of company that has employees in Mexico. Under the proposed legislation, if a company is granting fringe benefits to its employees, providing that certain rules have been complied with, frnge benefits to employees would be fully Mexican tax exempt. Under the Mexican tax reform proposal of 2014, the Executive Branch proposed a limitation on the deductions that companies can take on fringe benefits paid to employees up to fifty-three percent. In other words, if a company is making payment to its employees under the tax exempt fringe benefit regime of one hundred, only forty-seven percent of the expense would be deductible. The rest, the fifty-three percent, would not be deductible. Very importantly, this will not be applicable to maquiladoras, because, again, maquiladoras are not the same. They are not classified as are other Mexican companies. Maquiladoras recognize one hundred percent of their deductions, and those deductions will have to be marked up to the non-resident principal. Therefore, they have a different tax treatment, and will be treated differently from any current Mexican operation. That is one of the big advantages for maquiladoras at this state.

Tecma Group of Companies:

Is there a provision in the United States that allows companies operating in Mexico to claim credit on income taxes in Mexico? Is there an offset available to foreign manufacturers in Mexico?

Luis Carbajo:

That is correct, as long as you comply with certain requirements. In other words, it is a tax enacted in the law that states that a company is not voluntarily making a payment to the Mexican government. This is not the case, of course, because companies are obliged to pay the tax under Mexican law. Companies can get a foreign tax credit in the United States for income tax paid in Mexico provided that they have profits.

Tecma Group of Companies:

To summarize, under the Mexican tax reform of 2014, we have the IVA or the VAT (Mexican value-added-tax) postponed to 2015, and the income tax has been raised from 17.5% to 30%, but companies can consult with experts like yourself to utilizes deductions in the U.S. to minimize the impact. What do you see happening between now and 2015 that might change some of the things that have been negotiated thus far? Do you see things moving forward as planned, or might there be changes that occur the present and the beginning of 2015?

Luis Carbajo:

The maquiladora sector is very powerful, but not because it is powerful in and of itself. It employs, more or less, 2.3 million people directly, and perhaps seven or eight million indirectly. Mexico has big cities, mainly located in the border zone, that exist because of the maquiladora industry. These cities would include Tijuana, Ciudad Juarez, Reynosa and Matamoros, for instance. All of these cities are very important to the health of Mexico’s economy.

It is expected that further discussions will take place between members of the National Maquiladora Association (Index), and other important maquiladoras in Mexico, with the Executive Branch of Mexico’s government. It is necessary to further review specific rules, because we anticipate income tax changes to represent a significant hit to the maquiladora industry. There is a need to further discuss the projected imposition of VAT in 2015, and there are other issues that may cause negative effects for the supply chain structure of the maquiladoras. One of the big worries of the maquiladora industry is that the sale of goods located in Mexico between a foreign resident and a maquiladora will no longer be tax exempt, as they are at present. This is one of the big modifications to the VAT law, as well. This, the specific sales of goods, with delivery from one maquiladora to another with a virtual manifest, would have to be taxed at the sixteen percent rate. Of course, it is not clear, at this point, how these tax payments will be recoverable. We have issues with that. It is not clear in the bill if the purchaser of the goods will be able to credit the VAT, it appears that this will be the case. We need, however, to have clarification of the rules in the days to come and, therefore, it is expected that there will be a lot of discussions and lobbying activities going forward.

Tecma Group of Companies:

Luis, there are those issues that you just mentioned that are unclear right now, and part of the lack of clarity is that definitive action on these points of the Mexican tax reform has been put off until 2015. To recap for the listeners, however, as far as the process has transpired over the last few months, what concrete things are in effect that they can count on to be in effect between now and 2015?

Luis Carbajo:

A list of the accepted changes that have been accepted by the Mexican Senate and are going to be enacted, sooner or later, include several items. First, however, companies that are manufacturing in Mexico should do a full review to make sure that they qualify as a maquiladora in order to protect the foreign principal from permanent establishment status. Secondly, if the way the company is run creates protection from permanent establishment, the 17.5% income tax benefit that was applied before is gone. The company will have to pay thirty percent as of January 1, 2014. Thirdly, from a VAT perspective, we have already stated that the application of the new rules will regarding temporary importations will be postponed for a year. Companies will have to work proactively in order to get certification from the Ministry of Finance, as soon as possible, in order to be able to claim credit on the sixteen percent tax levied on temporary importations under the Mexican tax reform. Lastly, the most important item is to review the current deliveries that a maquiladora receives in Mexico in order to make sure that such deliveries are would not encompass a sale in Mexico for VAT tax purposes in Mexico. Again, sales made in Mexico, between a foreign resident and a maquiladora will be taxed at the regular, sixteen percent VAT rate.

Those are the most important items. There are other issues that are related to Mexico shelter operations, perhaps, or with a consolidation taxation regime that may also constitute a hit for big maquiladoras, but this is not the generality, if you will, for the sector.

Tecma Group of Companies:

This is a very complex issue that has a lot of different facets, as most of the listeners have been able to ascertain from what has been said here. Luis, if there are individuals that have listened to this and have questions for you on the Mexican tax reform, how can they contact you?

Luis Carbajo:

You can reach me at my email at: luis.carbajo@bakermckenzie.com

Tecma Group of Companies:

Thank you for this information Luis. Thank you for taking the time for shedding some light on this important issue.

Luis Carbajo:

Thank you for the invitation to speak on this topic.