MEXICO-Maquiladora Taxation: A Look At Four Troubled Areas
This article brought to you in conjunction with
By Narelle E. Mackenzie, William Major & Winfred Heitwritter (McGladrey & Pullen)
Even with the recent agreement reached by the US and Mexico on transfer pricing for maquiladoras, there are four potential "tune-up" areas that remain unaffected by the new agreement-separate maquiladora books; tax return reporting of the maquiladora operations with the US owner; maquiladora entity structure and relevant US tax depreciation rules.
Under Mexican law, a maquiladora is a corporation formed to assemble raw materials or components or both into finished goods, or conduct the labor-intensive steps in the manufacturing process. The main advantages of a maquiladora are that labor costs are considerably lower in Mexico, the US customs duty is limited to the portion of value added in Mexico and there is no Mexican duty if the goods are re-exported to the country of origin (i.e., the US). Maquiladoras can be owned 100 percent by US persons. The creation of a Mexican maquiladora requires a signed contract and approval from the appropriate Mexican authorities.
Accounting for Maquiladora Operations
In many instances, title to the goods never changes; at all times, the US parent retains title and the maquiladora process merely adds value to the goods. For this reason, many US taxpayers that own their maquiladoras do not maintain separate books and records for the two corporations; they simply combine the financial results. To prepare the US federal tax return from the companies' combined records, an additional entry in the books that reflects a maquiladora's separate company revenue and a corresponding expense to the US taxpayer is needed. Failure to make this entry may result in an overstatement of the US taxable income to the extent of the maquiladora's profit.
Consolidation with US Parent
Under Sec. 1504(d), Canadian or Mexican wholly owned subsidiaries are deemed to be domestic corporations and may qualify for consolidation with a US parent if they are formed solely to comply with the local foreign law for title and operation. In an IRS Coordinated Issue Paper (CIP) on the maquiladora industry, the Service concluded that a Mexican subsidiary formed to secure benefits under the maquiladora program in Mexico did not meet this test. The CIP limits the ability to elect to consolidate maquiladoras to those maquiladoras that have acquired title to the property and are located in a restricted zone (100 kilometers from the border or 50 kilometers from the coastline).
If a maquiladora does not satisfy the requirements for consolidation, but has been consolidated in prior years, a decision needs to be made as to whether a taxpayer should amend the earlier returns or deconsolidate prospectively. If the taxpayer deconsolidates after having made a Sec. 1504 election, the subsequent deconsolidation will be treated as a constructive Sec. 368(a)(1)(D) reorganization and will result in a constructive transfer of all assets of the "domestic" corporation to the foreign corporation in exchange for all of the foreign corporation's stock, followed by the exchange of the foreign stock with the (domestic) parent in complete liquidation of the "domestic" subsidiary. As a result of the constructive reorganization, Sec. 367(a) applies, potentially causing gain to be recognized on the deconsolidation if gain is realized on the deemed reorganization.
Generally, deconsolidation is not as painful as it might appear, because many of these same US taxpayers have paid foreign taxes in excess of their foreign tax credit (FTC) limits. Because the gains created on deconsolidation are often (at least to some degree) foreign-source, some of the associated federal tax liability is absorbed by existing FTC carryovers.
Mexican Entity Structure that Maximizes Return
The two principal entity choices for conducting maquiladora operations are a Sociedad Anonima (SA), a corporation; or a Sociedad de Responsabilidad Limitada (SRL), a limited liability company (LLC). Most Mexican businesses owned by foreign investors and multinationals are conducted through SAs, which generally cannot be classified as passthrough entities for US tax purposes. An SRL, however, may be characterized as a passthrough entity for this purpose.
A C corporation owning an SA may qualify for a credit for taxes paid by the Mexican entity, as the maquiladora generates taxable income through a Sec. 902 indirect tax credit. On the other hand, an S corporation partnership or certain LLCs establishing maquiladora operations through an SA may not qualify for a credit for the taxes paid by the maquiladora on operating profits in Mexico, because Sec. 902 only allows the indirect tax credit for C corporations. However, if an S corporation operates a maquiladora as an SRL and elects that the SRL be taxed as a passthrough entity for US tax purposes, any Mexican taxes paid by the SRL will be treated as if they had been paid directly by the S corporation and permitted as a direct tax credit under Sec. 901.
The effect of selecting a maquiladora entity on S shareholders can be illustrated by the following example.
Example: A maquiladora's profit (as measured under both Mexican and US tax accounting principles) is $100, the Mexican effective tax rate is 35 percent and the US effective tax rate is 40 percent.
If the maquiladora is conducted through an SA:
- Taxable profit $ 100
- Mexican tax (35)
- Dividend 65
- US tax (26)
- Net to US parent $39
If the maquiladora is operated through an SRL treated as a passthrough entity:
- Taxable profit $ 100
- Mexican tax (35)
- Dividend 65
- US tax (40)
- FTC 35
- Net US tax $5
- Net to US parent $60
Thus, the correct entity structure may result in significant after-tax savings to the US parent.
Depreciation Charge for Equipment Used by a Maquiladora
Many US parent corporations of maquiladora operations retain title to all the assets located in a maquiladora, but do not charge the maquiladora for the use of the assets. Because the US parent owns the assets, many US corporations use regular US lives and methods of tax depreciation. Sec. 168(g)(1)(A), however, requires that assets used predominantly (i.e., more than 50 percent) outside the US be depreciated under the alternative depreciation system. As a result, depreciation must be calculated on a straight-line basis and over lives that are often about twice as long as US-use assets. This results in a significantly lower tax depreciation expense for the US parent.
Narelle E. MacKenzie, William Major and Winfred Heitwritter are with the accounting firm of McGladrey & Pullen. Narelle MacKenzie is with San Diego, California office, William Major is with the Schaumberg, Illinois office, and Winfred Heitwritter is with the firm's San Bernadino, California office. This article previously appeared in the April 2000 edition of The Tax Adviser.
For more stories like this, go to http://www.wtexec.com/mexfor.html.