The Income Tax Implications of Permanent Establishment in Mexico
November 16, 2020
Once your company has established a manufacturing operation in Mexico, then you have “permanent establishment” (PE) or a fixed place of business that makes you responsible for paying income taxes as a Mexican resident. Or do you?
The answer depends upon the strategy you use to bring your operation to fruition, a strategy that should be carefully considered to maximize the cost benefits available from operating in Mexico.
Background on PE
In September 1992, the U.S. and Mexico signed the Convention Between the Government of the United States of America and the Government of the United Mexican States for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, together with a related Protocol (U.S. – Mexico Income Tax Convention). The U.S. – Mexico Income Tax Treaty entered into effect on January 1, 1994.
In a nutshell, the Convention “is aimed both at avoiding double taxation and avoiding evasion or avoidance of the tax laws of either the U.S. or Mexico” (see Geoffrey R. Polma, The New US-Mexico Income Tax Treaty: Overview and Analysis, Law and Business Review of the Americas). By doing this, both the U.S. and Mexico hope and believe that the Convention “will facilitatedirect and portfolio investment between the U.S. and Mexico.” Among the most important functions of the Convention are the reduction of withholding tax rates and the standardization of the creditability of each country’s taxes against the taxes imposed by the other country.
Triggers for Permanent Establishment in Mexico
Article 5 of the U.S. – Mexico Income Tax Convention provides that U.S. companies are considered as having a PE in Mexico if, among other, one of the following tests is satisfied:
Does the U.S. company have a fixed place of business within Mexico? If this answer is yes, the U.S. company can be considered as having a PE in Mexico. A fixed place of business includes a company branch, an office, a factory, a workshop, a mine, or even a gas/oil well.
Does the U.S. company operate in Mexico through a dependent agent? If the answer to this question is yes, then you must ask the following two questions:
Does the dependent agent regularly enter into contracts in Mexico on behalf of the U.S. company?
Does the dependent agent processes inventory located in Mexico owned by the U.S. company using tools belonging to the U.S. company?
If the answer to either of these two questions is yes, then the U.S. corporation can be considered as having a PE in Mexico.
Keep in mind, in order to determine whether a U.S. company is subject to a PE in Mexico, the Mexican Tax Authority (SAT) must take into consideration not only the language in the U.S. – Mexico Income Tax Convention but also the most recent version of the relevant Commentaries on the Articles of the Organization for Economic Co-operation and Development (OECD) Model Tax Convention on Income and on Capital (See Rule 2.1.53 (I), Resolución Miscelánea Fiscal).
After the SAT determines that the U.S. company has a PE in Mexico, the U.S. company is subject to the same income tax laws and regulation applicable to a Mexican resident, leading to a heavier tax burden.
Income tax burden under shelter service providers
Depending on how your company enters into manufacturing operations in Mexico, you may not in fact have permanent establishment in Mexico. Typically, companies operate in Mexico within one of five models: i) as a standalone corporation; ii) through a contract partner; iii) within a merger or acquisition; iv) under a joint venture; or v) under a shelter service provider. A significant benefit for foreign companies manufacturing in Mexico under the shelter service umbrella is the tax incentives associated with IMMEX certification.
Tax consultants PwC explain that companies that begin operating in Mexico under the umbrella of a shelter service provider are not considered as having PE in Mexico. As long as the company and its shelter service provider meet certain requirements, and provide information on revenue and income taxes paid to the resident country to the Mexican Tax Administration, then the foreign company will not be taxed as a Mexican resident (i.e., as having a PE in Mexico).
Among the conditions that must be met are the requirement that the foreign company must be a resident of a country that has entered into a Tax Information Exchange Agreement with Mexico, and that the shelter service providercomplies with safe harbor provisions to determine its tax profit, as laid out by the Mexican Income Tax Law (Ley del Impuesto Sobre la Renta), or secure a private ruling under the OECD Transfer Pricing Guidelines from the SAT, as provided for in the Federal Tax Code. The tax liability imposed on a U.S. company under either the safe harbor provisions or a private ruling should be creditable in the U.S. under Sections 901 and 903 of the Internal Revenue Code of 1986 (i.e., tax in lieu of an income tax).
Comply for complete cost savings
Mexico works hard to maintain its business-friendly climate and encourage foreign direct investment. After all, foreign investors employ Mexico’s skilled workforce, strengthen educational infrastructure around the country, and support the economy with spending activity. However, it is important for these companies to comply with all federal tax laws to ensure they realize the tremendous cost benefits of manufacturing in Mexico.
By partnering with an experienced shelter service provider, foreign investors gain both expert insight and a partner able to manage compliance with all legal requirements. Not only can this partnership lower your risk of expensive fines, but it can also speed your operational startup and lower long-term costs.
To learn more about Manufacturing in Mexico, watch a recording of our recent webinar below:
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