Executive summary

The US Internal Revenue Service (IRS) on October 14, 2016 (IR-2016-133) announced that US taxpayers seeking unilateral advance pricing agreements (APAs) with Mexico for their maquiladora operations will not be exposed to double taxation as long as the intercompany pricing is under the framework to which the US and Mexican competent authorities have agreed in advance.

Detailed discussion

Maquiladora structures

Maquiladoras are Mexican companies that engage in export manufacturing operations with foreign residents that provide the inventory and M&E required to manufacture finished products owned by the foreign residents. The maquiladoras charge a manufacturing service fee, which is usually based on the costs of the maquiladora, plus a mark-up.

To the extent that the maquiladoras comply with certain requirements, the foreign residents engaging in manufacturing operations through those companies are not considered to have a permanent establishment in Mexico.

Among one of the new requirements applicable to maquiladoras starting from January 1, 2014, is that the service fee charged to the foreign resident is determined in accordance with any the following alternatives:

1. The "Safe Harbor" method, which requires the maquiladora to earn taxable profit in an amount equal to the greater of: (a) 6.9% of the total value of the assets used in the maquiladora operation (i.e., foreign-owned and Mexican-owned), or (b) 6.5% of the total amount of costs and expenses incurred in the maquiladora operation, or

2. An advance pricing agreement (APA) in which the return earned by the maquiladora is determined considering the value of the foreign owned-assets used in the maquiladora operation.

APAs

The APA program is a voluntary process whereby tax authorities and taxpayers resolve transfer pricing issues in a principled and cooperative manner on a prospective basis. By agreeing on the transfer pricing method to be applied during the term of the APA, the taxpayer achieves certainty of tax treatment. In the US, other benefits may include freedom from exposure to penalties under Section 6662(e), freedom from a transfer pricing adjustment by the IRS and, if the APA is bilateral, freedom from double taxation created by different reporting in the US and the other involved country.

From a Mexican perspective, the APA is one of the alternatives available to maquiladora companies to comply with transfer pricing requirements and to protect the foreign resident that owns that inventory and assets used in the operation from creating a permanent establishment in Mexico. Since 2014, it is estimated that between 700 and 800 maquiladora companies filed for an APA and the SAT is expecting to resolve a portion of these APAs under the methodology agreed with the IRS, which is being referred to as a "Fast Track" methodology.

SAT

The SAT will be notifying eligible maquiladora taxpayers with pending unilateral APAs about an election to apply the "Fast Track" methodology agreed in advance with the IRS, which will produce arm's-length results. The detailed and final terms of the methodology agreed between the SAT and IRS has not been publically disclosed, although the SAT shared a draft version in the past weeks. There has also been no official information regarding the terms under which the APAs will be implemented; for example, whether companies will need to amend prior year tax returns or not, if additional tax payments will be subject to surcharges and penalties, or the criteria to determine which companies will be qualify.

The IRS, however, has explicitly stated that the transfer pricing results set forth in unilateral APAs executed between SAT and Mexican affiliates of US taxpayers under the framework will be regarded as "arm's length" under Section 482.

This announcement adds to the agreement from 1999 to reflect recent changes in Mexican law regarding transfer pricing and other tax matters. Per the IRS announcement, two years of working with their SAT counterparts has led to this framework, which will hopefully help to resolve a portion of the maquiladora unilateral APA requests currently sitting with the SAT.

Implications

SAT will directly notify qualifying Mexican taxpayers about the steps they must take regarding their pending unilateral APA requests. Selected companies must carefully evaluate the implications of the proposed methodology in the context of their current tax position. Taxpayers who decide to decline the election may continue with their APA process under the standard procedure; it is not clear, however, when the SAT will define the methodology or additional information that will be required to resolve maquiladora APAs under the standard procedure. Additionally, maquiladoras may request a bilateral APA with the IRS and SAT (for cases in which the foreign resident contracting with the maquiladora is a resident of the US) or may also consider applying the safe harbor methodology on a going-forward basis (the application on a retroactive basis is not certain subject to compliance with formal requirements).

Unfortunately, companies that are not selected under the proposed "Fast Track" process will need to continue to wait for the SAT to define the methodology and criteria to resolve the pending APAs, which is one of the most important requirements to ensure that the foreign resident contracting with the maquiladora does not create a permanent establishment in Mexico.

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