It is not uncommon for U.S. businesses, large and small, to unintentionally make decisions that impact the business for years to come. In the planning you do before you go, you should be aware of these tax and financial statement considerations.
1. Oops! I think I just created a permanent establishment in Mexico
Even if a company does not have a physical presence in the form of an office or a plant in Mexico, the activities performed there on behalf of the company could create a “permanent establishment” (“PE”), which may cause the company to be obligated to pay taxes in Mexico. Generally, a PE is created by a person when that individual is in Mexico for 183 days in a rolling 12 month period. While an individual only needs to be concerned with the number of days they themselves spend in Mexico, a company could create a PE by sending multiple employees to Mexico during a rolling 12 month period. For example, if a company sends four employees to Mexico for a 46 day project, they have likely created a PE (4 employees times 46 days = 184 days the company was “in Mexico”). It is important for companies to be aware of these rules because it is much easier to plan before hand than it is after the fact.
2. I think I want to do business in Mexico. What are my options?
If a company has a project that needs to be done in Mexico, or, they have a customer pushing them to expand into Mexico, they have a few different options:
Utilize a “shelter” company which does not create a PE for the U.S. company. It also makes pulling out of Mexico easier if it is not as profitable as the company believed it would be, or if the company loses the contract with the customer that brought them to Mexico in the first place. But, there is a price for these benefits. The shelter company is a business and needs to make a profit, so, this option is more expensive than the other options, making it a short-term solution for many companies. This option tends to work best for companies with limited infrastructure.
Create a separate legal entity in Mexico (a wholly-owned subsidiary). This is probably the best long-term solution for tax purposes.
Treat the company’s Mexican activities as a branch of the company. This is usually the worst situation for tax purposes as it may subject other aspects of the company to tax in Mexico.
3. Proper tax planning: it’s worth the investment
If a company chooses to create a separate legal entity in Mexico, deciding which type of legal entity and then making the proper timely elections in the U.S. could have a substantial tax effect, as illustrated here:
|Entity – Type A|
|Taxable income of Mexico entity||$100,000|
|Mexican tax (assuming 30% rate)||(30,000)|
|Dividend to U.S. Parent company||$70,000|
|U.S. tax on dividend (assuming 39.6%)||(27,720)|
|Net cash after all taxes paid||$42,280|
|Entity – Type B|
|Taxable income of Mexico entity||$100,000||$100,000|
|Mexican tax (30% Mexico, 39.6% U.S.)||(30,000)||(39,600)|
|U.S. Foreign Tax Credit||0||30,000|
|Net cash after all taxes paid||$60,400|
|Tax savings of Entity B over Entity A||$18,120|
This is a simplified example used to illustrate the difference entity type and tax elections can make. Each company’s facts and circumstances are different, so, we encourage you to contact us to review your situation prior to beginning to do business in Mexico.
4. But wait! There’s more – more reporting requirements, that is
Doing business in Mexico could subject a company, and possibly it’s officers, to penalties if certain reporting requirements are not met. There are reporting requirements for anyone with signature authority over certain foreign bank accounts, even if the individual does not have a financial interest (i.e., an officer of a U.S. company with signature authority over a Mexican bank account). There are also reporting requirements when U.S. companies transfer cash to foreign entities. Although there is no tax associated with these IRS forms, many of these reporting requirements carry stiff penalties for non-compliance, generally $10,000 minimum penalty for filing these forms late.
The U.S. is not the only country with reporting requirements; Mexico requires transfer pricing studies to be filed with a company’s Mexican tax return if there are related party transactions. Transfer pricing rules have been enacted by both U.S. and Mexican governments to prevent related parties from shifting income to low tax jurisdictions by requiring that arm’s length pricing (the price negotiated between two unrelated parties) be used when engaging in transactions between commonly controlled businesses. While a formal transfer pricing study is not required by the IRS, it is required by the Hacienda (Mexican IRS).
The Mexican government also requires companies to obtain a financial statement audit once revenues are greater than USD $4M or over 300 employees.
5. Other taxes you should know about before doing business in Mexico
In addition to income taxes, companies doing business in Mexico may be subject to withholding taxes on interest, royalties or dividends, and Value Added Tax (“VAT”) on certain services. The VAT can be particularly tricky if a U.S. company is doing business in Mexico because they could receive payments net of VAT withholding (currently at 16%) with no inexpensive means to request a VAT refund. They may find themselves in a situation where it would cost them more to file the appropriate paperwork than the VAT withholding.
6. Hiring employees in Mexico can’t be that different than it is in the U.S., or can it?
Employment laws are quite different in Mexico compared to the U.S. While payroll taxes are similar to the U.S., the Mexican government requires holiday pay, Christmas bonus pay, severance pay and even profit sharing of 10% of the company’s income. If a company properly plans, they can establish various tax planning ideas to help control the amount of profit sharing required.
7. Enough about taxes, what about financial statements and loan covenants?
According to generally accepted accounting principals (“GAAP”) in the U.S., wholly-owned subsidiaries (even those located in Mexico) must be consolidated for financial reporting purposes. Consolidating a U.S. parent’s financial statements with a Mexican subsidiary’s financial statements can present some challenges.
First, the subsidiary will most likely maintain their books and records denominated in the Mexican peso (the functional currency). When the financial statements of the subsidiary are converted to U.S. dollars, there will be a translation adjustment, which if currency fluctuations have been significant, could cause the company to fail loan covenant requirements.
Secondly, Mexican GAAP’s definition of inflationary economic environment differs from that of U.S. GAAP, which means a Mexican subsidiary could be required to recognize the effects of inflation on financial information even though U.S. GAAP requires the parent company to not recognize the effects of inflation.
The above information and examples are simplified to give a broad overview of the issues.