Companies with Mexican subsidiaries may be wondering how best to proceed in light of COVID-19. Below are 10 recommendations to help weather the storm:
- Reduction of the income tax coefficient – Federal income tax estimates are due monthly and are based on a coefficient determined on the taxable income of the previous fiscal year. Based on the mechanics of this calculation, companies with major disruption of business during the COVID phase will still be paying income tax, even though their projections may show negative projected profits in the current year. Within the federal income tax guidelines, there are provisions to reduce the income tax coefficient allowing for a reduction in the monthly estimated income tax payments. These provisions are often overlooked by companies and can be extremely helpful in managing cash flow during a business disruption.
- Example – Manufacturing Brakes & Filters de Mexico (Tier 1 & 2 auto supplier) had an outstanding 2019 year, however, for Q1 of 2020, as with most companies, has suffered the effect of the OEM & economic shutdowns. Refer to the table below to illustrate Manufacturing Brakes & Filters de Mexico option.
|July – December 2020 (without reduction of coefficient)||July – December 2020 (presumed with reduction of coefficient)|
|Income Tax Coefficient||.0800||.0800||.0000|
|Income Tax Rate||30%||30%||30%|
|Total Taxes Anticipated||240,000||120,000||0|
Because of the implementation, Manufacturing Brakes & Filters de Mexico have added 120,000 USD of free cash flow during 2020.
- Liabilities in pesos – Companies with financial obligations due in Mexican pesos should consider paying such balances now due to the strength of the U.S. dollar. Between the actual and anticipated losses caused by COVID-19 and the impact of the sharp decline of oil prices in Mexico, a historic oil-producing country, the Mexico peso devalued by more than 30%. This means that companies need 30% less USD to liquidate its Mexican peso obligations.
- New obligations in the Mexican peso – Establish future obligation contracts in peso as a way to reduce the risk of volatility of the Mexican peso versus the USD. If a suppliers’ main cost component is labor in Mexico, they should consider negotiating obligations based in Mexican pesos.
- Include clauses for future foreign exchange fluctuation – When future revenue-generating contracts must be in Mexican pesos, and the costs of products and services are based in USD, consider establishing clauses to contracts that provide a “ceiling” and “floor” on exchange rate fluctuations. This way, if a significant fluctuation occurs, customers have established a quarterly or monthly update to the agreement that revises payment terms. Additionally, in order for businesses to avoid the risk of a significant exchange rate fluctuation between the day a purchase order is sent, and the day the company is invoiced, companies should consider having terms that lock in the rate based on the purchase order date.
- Foreign exchange forward hedging instrument – Another way of mitigating the foreign exchange volatility is using forward hedging instruments that will lock the exchange of Mexican peso and USD at a specific rate, and provides the option of buying a specific amount of USD at a future date with today’s exchange rate. The cost of this type of financial instrument varies. One of the main drivers is the time of the expected settlement date. Refer to the example below to illustrate the mechanism of the forward hedging instrument.
- Example – Plastic Injection de Mexico will receive a payment of 10,000,000 MXP for dunnage parts that were sold in January 2020. The estimated timing for receipt of payment from the OEM is April 10, 2020. Clayton & McKervey had advised them in January to look into a forward hedging instrument. The Company was provided with the following quote for a forward foreign exchange instrument as follows:
Exhibit A – Forward Contract Information
|Liquidation date||Notional||Spot @ Jan 9, 2020||Forward Points||Forward Cost|
|April 13, 2020||10,000,000||18.9600||$0.3512||$19.3112|
Exhibit B – USD equivalent with and without the forward contract
|Scenario A (with financial instrument)||Scenario B (without financial instrument|
|Payment from OEM on April 10, 2020||10,000,000 MXP||10,000,000 MXP|
|Exchange of payment into USD||517,834 USD||424,367 USD|
- Factoring agreements or offering early payment discounts to customers – With businesses suffering major disruptions, cash management will be key. It is anticipated that many will be experiencing a delay on the collection of accounts receivable. Those companies should consider strategies such as the use of factoring agreements to accelerate collections or offering early payment discounts to provide incentives for customers to pay early.
- Competitive new quotes – When quoting new projects, consider the impact of exchange rates on pricing. Will the costs of the project be paid in Mexican pesos while the revenue received in U.S. dollars?
- Comparison of leasing in USD v peso? – Contracts for the lease or purchase of land for commercial and industrial buildings in certain industrial parks are based in USD; however, there are multiple developments that set their prices in Mexican pesos.
- Example – Pistons de Mexico has been in an industrial park for over 4 years in the state of Guanajuato, during Q4 of 2020 they started searching for a facility with a larger capacity. Pistons de Mexico selected two properties to compare for the final decision. Piston de Mexico was considering Facility A that is based in USD and facility B based on Mexican Pesos. Refer to the analysis below to illustrate how exchange rates have become a very important factor in the thought process of Pistons de Mexico.
|Facility A (facility based in USD)||Facility B (facility based in MXN)|
|Cost of facility as of December 31, 2019||470,000 USD||11,000,000 MXP or 582,852 USD|
|Cost of facility as of April 15, 2020||470,000 USD||11,000,000 MXP or 466,803 USD|
|Difference in USD||0 USD||116,049 USD|
- State tax incentives – At a Federal level there has not been an economic stimulus package, or tax package, benefits Mexican companies. Nonetheless, certain states have offered stimulus packages for companies that reside in such states. We can help you explore the opportunities available so that you do not miss the chance to benefit from these incentives.
- Changing currencies in intercompany repayments of loans – We have seen that in most of our client’s intercompany loans are one of the biggest liabilities of the subsidiaries. In most cases, there are no short or mid-term repayment plans for such loans. In order to reduce the income tax in Mexico looking into the intercompany agreements and potentially updating the currency of the future loan repayments could generate a considerable realized loss in the exchange rate that could benefit the subsidiary in future years. Any changes need to be compliant with arms-length standards and it’s an alternative that might need to be reviewed by a transfer pricing specialist.
If you need help with foreign exchange planning, site selection, tax planning, or obtaining tax incentives we can prepare a tailor-made COVID 19 plan for your subsidiary to put you in a good position for the future despite today’s challenges.
The above represents our best understanding and interpretation of the material covered as of the date of this post. Things are moving at a rapid pace, and as such, information is subject to change. This information is provided for informational purposes only and is not intended to be a substitute for obtaining accounting, tax, or financial advice from an accountant.