April 23, 2021
Mexican Congress approves labor reform addressing outsourcing services
The amendments to the labor and tax laws will require many businesses to reorganize their operations in Mexico to eliminate subcontracting arrangements. Specialized service providers will need to register with the Labor Department.
After months of discussion and lobbying, Mexico's two houses of Congress approved on April 20, 2021, the labor reform (the Final Reform), which affects the ability of businesses to outsource most services in Mexico. To accomplish this objective, the Final Reform includes changes to the Federal Labor Law, the Federal Tax Code, the Income Tax Law and the Value-Added Tax (VAT) Law, as well as the Social Security Law and National Employee Housing Fund Law (Payroll Tax Laws). For more information, see Tax Alerts 2020-2697, 2020-2824 and 2021-0815.
The Final Reform will be effective the day after publication in the Official Gazette (which is expected to happen on May 1, 2021) for labor law purposes, although a transitory three-month period expiring on August 1, 2021, is granted to allow employers to restructure. The tax provisions of this reform would enter into force on August 1, 2021 as well. Companies should therefore evaluate options to be comply with the Final Reform. With only three months to comply with the Final Reform, taxpayers may want to analyze their operations as soon as possible to reduce implementation delays that could result from COVID-19.
Overview of the Final Reform
The Final Reform is consistent with the overall intention of the original bill submitted in November in terms of prohibiting outsourcing services, except for qualified specialized services or specialized projects. In line with the changes to the Labor Law, the Income Tax and VAT Laws and the Federal Fiscal Code are amended to (1) disallow the deduction for expenses related to nonqualified services and the VAT credit for payments of nonqualified services, (2) establish rules for the deduction and credit of payments for specialized services and specialized projects , and (3) establish joint liability and penalties for non-compliance. Payroll Tax Laws also were amended to (1) allow subcontracting services only for qualified specialized services or specialized projects, (2) require reporting for specialized services or specialized projects, and (3) clarify joint liability and penalties for non-compliance.
Many businesses and corporate groups in Mexico are set up with separate service companies that house the employees; these service companies may serve one or more operating companies. To comply with the Final Reform, these businesses must transfer the employees to the company for which the employee is providing the service. An evaluation should be made as to shared services, such as general management, accounting, finance, etc. and whether these types of activities may qualify as specialized services.
As the Final Reform applies to all subcontracted services, businesses must also evaluate their service agreements with third parties and make sure that service providers are properly registered as specialized service providers, if applicable. In addition, a service company may have to evaluate customer by customer whether services may be rendered under the exception for specialized services and specialized projects.
Federal Fiscal Code
The Final Reform amends the Federal Fiscal Code to provide that payments for subcontracted services, except payments for specialized services or specialized projects, are not deductible and the corresponding VAT is not creditable. The Final Reform also establishes the applicable penalties for non-compliance and joint liability rules.
Specifically, payments for subcontracted services related to the taxpayer's corporate purpose or primary economic activity will not be deductible or creditable for tax purposes. Taxpayers also will not be allowed a deduction or VAT credit for payments for subcontracted services when the personnel involved in the rendering of services were formerly employed by the recipient of the service and transferred to the service provider.
Payments for services unrelated to the corporate purpose or primary economic activity may be deductible or creditable to the extent the service provider is registered in the Specialized Services Provider Registry as required by the Labor Law and all other compliance requirements are met.
Taxpayers that improperly deduct expenses or claim a VAT credit for payments to service providers for outsourcing services may be subject to a penalty of up to 75% of the omitted tax.
Additionally, providers of specialized services that do not provide the information required for income and VAT purposes to the service recipient will be sanctioned with a fine of approximately USD $15,000 per instance of non-compliance.
The Final Reform treats the simulation of specialized services or projects (i.e., the fraudulent characterization of services or projects as specialized) as a qualified tax offense, which carries greater criminal consequences, such as pre-trial detention, special investigation tactics, and longer-term convictions.
For a service recipient to claim a deduction for payments for specialized services or projects, the Final Reform requires the recipient to verify that the service provider is registered with the Labor Authority as a specialized service provider. The recipient also must obtain detailed information from the service provider about the payment of salaries and taxes on the amounts paid to the employees. The Final Reform specifically requires the service recipient to obtain the following items to support the deduction for payments to the provider: (1) copies of the payment receipt for each employee's pay, (2) a copy of the wire transfer showing the remittance to the tax authorities of the tax withholdings on employee payroll, and (3) copies of the payment receipt for social security and housing contributions.
This type of information has been required by the tax authorities in the past for service payments. The detail level and amount of information to be provided is not clear at this point, because a service provider may provide services to multiple clients and the remittances to the tax authorities are based on the aggregate amount for all the employees and do not necessarily include a breakdown per client.
Like the income tax requirements, the service recipient must verify that the service provider is registered with the Labor Authority to claim a credit for the VAT paid for specialized services. The service recipient must also obtain from the service provider a copy of the provider's VAT tax returns and wire transfer demonstrating the remittance of the VAT to the tax authorities. The service recipient must provide this information by the end of the month following the month of payment.
Because the VAT return includes information on an aggregate basis and not necessarily on a project or client-by-client basis, the service recipient may have to conduct a reconciliation to show that the VAT related to a specific project or client is included in the amounts reported and remitted to the tax authorities.
Impact on profit sharing
The Final Reform amends the Labor Law to include a cap on the profit-sharing amount to be paid to each employee. Under the cap, the profit-sharing amount may not exceed three months of salary or the average amount of profit sharing received by the employee in the past three years, whichever is more favorable to the employee.
The Final Reform did not modify the other provisions on profit sharing. As such, the total profit-sharing amount to be distributed will be 10% of taxable income (pre-tax and pre-profit-sharing income for the current year with no reduction for net operating loss carryforwards under income tax rules). Also, the profit-sharing amount per employee will continue to be determined based on a specific formula under which 50% is allocated based on the number of days worked and the other 50% is allocated based on salary levels. Once these amounts are determined, the cap introduced under the Final Reform will be applied for each employee.
There are some pre-existing caps and limits on profit sharing that continue to apply. For example, officers and directors of the company do not qualify for profit sharing, and the one-month salary cap for specific sectors still applies.
Exceptions for specialized services and specialized projects
Subcontracting is now defined as legal or physical persons putting their employees at the service or disposal of another person. Specialized services are those not related to the corporate purpose of the company or primary economic activity of the business. The Final Reform also provides that shared and complementary services rendered between members of a group of companies will be considered specialized services to the extent they do not relate to the primary business activity of the entity receiving the services.
Specialized service providers, including related parties, must be registered in the Specialized Services Provider Registry to be maintained by the Ministry of Labor, which will require submitting certain information to the Labor Department. The registration will be valid for three years.
The Final Reform requires labor authorities to issue regulations on the specialized services registry within 30 days of the law's effective date. Companies will then have 90 days as of the publication of the regulations to register with the Specialized Services Provider Registry. These are shorter periods than prior drafts of the reform, which included a four-month period for the issuance of regulations, and six months for companies to register.
To the extent the specialized services provider does not comply with its labor and social security obligations, the registration may be revoked. The social security administration must inform the labor department of non-compliance with these provisions.
Likewise, in the event of noncompliance by the specialized services provider, recipients of specialized services will be jointly liable for the service provider's tax liabilities for the personnel who performed the relevant service.
Reporting for specialized service providers
For specialized services or specialized projects, the Final Reform includes several reporting requirements:
1. Labor law
Specialized service providers must register with the Specialized Services Provider Registry, which will require employers to provide information and documentation required under the regulations and to comply fully with their tax and social security obligations.
2. Social Security
The Social Security Law requires quarterly reporting of service agreements entered each quarter. Service providers must provide information about the parties to the agreement, such as the tax identification numbers, addresses, phone numbers and e-mail addresses, as well as the purpose of the agreement and length of time the agreement will be in effect. The Final Reform also requires the service provider to report a detailed list of employees involved in the rendering of services, including extensive social security information on each employee.
3. Institute of the National Housing Funds for Workers (INFONAVIT)
The INFONAVIT Law also requires service providers to report service agreements entered on a quarterly basis. Like the social security requirements, the service providers must report certain details for each agreement, including the amounts for housing contributions, base salaries, and employees' information, among other things.
4. Tax disclosures
Specialized service providers will be required to provide certain tax information to the service recipient for the recipient to claim a deduction for payments made for the services or a VAT credit for the payments. This information includes (1) copies of payment stubs of the employees involved in the rendering of the specialized services, (2) copies of wire transfers showing the remittance to the tax authorities of the tax withholdings on employee salaries, and (3) proof that social security quotas and housing contributions were paid. In addition, the service provider must provide copies of VAT returns and wire transfers reflecting the remittance of VAT to the tax authorities.
The implications of the Final Reform are quite extensive and require a careful analysis of all current outsourcing and service arrangements for compliance purposes. While transition rules give companies time to make the necessary adjustments, the period allowed is tight considering that the analysis must take into consideration tax, legal, labor, systems and operations implications. Additionally, the actual implementation and execution of the steps are subject to several formalities and documentation requirements.