By Jesús Aldrin Rojas M. LC, MBA, MGM, Transfer Pricing Expert Witness to the Mexican Federal Judicial Council, Managing Partner at QCG Transfer Pricing Practice, Mexico City
Mexico’s reform to various tax and labor laws to prohibit outsourcing of personnel, published in the Official Gazette on April 23, has important tax and transfer pricing considerations for business groups in the country. The tax reform provisions, which take effect August 1, will limit eligibility to claim certain deductions and credits. Meanwhile, to comply with the outsourcing reform, businesses will have to consider several scenarios to avoid significant penalties.
Outsourcing reform
The reform published on April 23 revises, adds, and repeals various provisions affecting outsourcing-insourcing schemes in Mexico. It includes amendments to the Federal Labor Law, Federal Tax Code, Income Tax Law, and Value Added Tax (VAT) Law, among other laws.
The reform, via article 12 of the Federal Labor Law, prohibits the subcontracting of personnel, understood as when an individual or legal entity provides or makes available its own workers for the benefit of another. In connection with this provision of the Federal Labor Law, the Federal Tax Code in article 15-D even extends this prohibition to those cases in which the contracting party receives services from the contractor through personnel who have previously worked for the contracting party and have been transferred to the contractor by means of any legal mechanism.
The only subcontracting allowed, as established by the Federal Labor Law in article 13, is that of specialized services or specialized works, if they are not part of the corporate purpose of the company receiving the services, nor of its predominant economic activity.
Moreover, the contractor must be registered in the public registry authorized for this purpose – Register of Specialized Services or Specialized Works (REPSE) – at the Ministry of Labor and Social Welfare, having previously confirmed that they are up to date with their tax and social security obligations (article 15 of the Federal Labor Law). Specialized services are also required to be formalized by means of a contract, as established in article 14 of the Federal Labor Law.
In the area of intra-group operations, article 13 of the Federal Labor Law establishes that the complementary or shared services or works provided between companies of the same corporate group shall be considered specialized services if they comply with the general requirements of not being part of the corporate purpose of the recipient of the service or forming part of its predominant economic activity and (it is assumed) that they have been registered in the REPSE.
The Federal Labor Law considers as a “group” what is established in the Securities Market Law in article 2, section X: “A corporate group is the group of legal entities organized under schemes of direct or indirect equity participation, in which the same company maintains control of such legal entities. Likewise, financial groups formed under the Law to Regulate Financial Groupings shall be considered as a corporate group.”
Finally, the reform proposed in article 127 of the Federal Labor Law proposes that employees share in profits of the companies for which they work for up to three months of the employee’s salary or the average of the participation or share received in the last three years, whichever is more favorable.
Tax implications
The reform sent by the Federal Executive, is, in principle, of a labor nature. In this context and with the purpose of discouraging the use of outsourcing schemes for personnel, the Federal Labor Law in article 1004-C establishes significant penalties.
Fines of 2,000 to 50,000 “units of measurement and updating” (UMAS) apply to whoever persists in personnel subcontracting activities or does not obtain the registration in the REPSE. The value of the UMA for 2021 is MXN 89.62 daily (approximately USD 4.46 USD) per UMA. Likewise, impeding the inspection or surveillance of the authorities in the workplace carries penalties ranging from 250 to 5,000 UMAS according to article 1004 of the Federal Labor Law.
Notwithstanding the above, the most important sanctions are not of a labor nature but of a tax nature. The Federal Tax Code in article 15-D establishes that taxpayers that contract specialized services will be ineligible to deduct for income tax purposes, or to credit for value added tax purposes, amounts arising from subcontracting operations of personnel or specialized services not registered.
Deductibility of expenses for income tax purposes may even be denied if the recipient of the services does not verify that the lender has met the established requirements in article 27-V of the Mexican Income Tax Law, which includes various registration, payment, and documentation requirements.
If specialized service providers fail to comply with their documentation delivery obligations, they would also be subject to the sanctions established in articles 81 and 82 of the Federal Tax Code, that is, between MXN 150,000 and MXN 300,000 for each of the items previously mentioned in section V of article 27 of the Income Tax Law (approximately USD 7,500 to USD 15,000).
Even so, the taxpayer receiving the services will find that they will also be unable to credit the VAT on the transactions if they also do not comply with the requirements established by article 5 of the VAT Law and obtain from the service provider the required documentation.
Finally, article 108, i), of the Federal Tax Code was amended to criminalize as a tax fraud offense the use of simulated schemes for the provision of specialized services or the execution of specialized works that do not form part of the corporate purpose or the predominant economic activity. This is the case even when (and in accordance with the general rule) personnel services are rendered with employees who were originally employees of the contractor and have been transferred to the contractor by means of any legal mechanism.
The labor reform proposed by the Federal Executive will take effect in the Federal Tax Code, the Mexican Income Tax Law and the Value Added Tax Law on August 1.
Main transfer pricing implications
In view of the outsourcing reform, a large number of business groups in Mexico will be faced with the dilemma of entering into employer substitution, merger or spin-off schemes. Each of these options has different transfer pricing implications.
Commonly in employer substitution transactions there will be cases of disposal of tangible assets to comply with the requirement established in articles 41 of the Federal Labor Law, as well as the 4th transitory article of the reform decree. In these cases, there should be no further complexity, since the transfer of tangible assets should be resolved through the implementation of the comparable uncontrolled price method in comparison to the prices or amounts of consideration agreed upon in transactions involving the disposal of assets comparable to those that would be the subject of the intercompany transaction.
It would be difficult to dispose of intangible assets generated by specialized work teams, because this would presuppose that the disposing entity did not limit itself to the development of recruitment, selection, training and outplacement activities, typical of a company providing personnel services. Rather, its activities would have involved developing intellectual property, and therefore, in the event of a transfer pricing review, an adjustment to the taxable base would be triggered to recognize an adequate remuneration for such activities. This contingency would remain until the tax authorities’ verification powers were extinguished.
However, the most visible effect of the labor reform on transfer pricing has to do with cases in which the former personnel services companies decide to convert themselves into specialized services companies through employer substitution in accordance with the provisions of the 7th transitory article of the reform. (Such a transaction, by the way, should not be considered a corporate restructuring subject to the reporting requirements under Title VI of the Federal Tax Code and action 12 of the OECD BEPS plan, since there is no tax purpose pursued by the taxpayer).
In these cases, and in the first instance, the alignment of the corporate objectives of the companies belonging to the corporate group will be of paramount importance. There should be no concurrence between their corporate objectives and/or predominant economic activity.
Ideally, the recipient of the services should identify precisely what its activities will be (e.g., wholesale marketing of durable goods, manufacture of automotive parts) and align its strategy, functions, assets and risks to that corporate purpose. The same should apply to companies providing specialized services that, by exclusion to the corporate purpose of the contracting party, should in turn limit their corporate purpose and consequently functions, assets and risks to the support activities that are necessary to the recipient of the services (i.e., human resources, information technology, legal support, etc.).
The characterization of companies providing specialized services will have an immediate effect on the profit to be attributed to them and therefore on the payment of employee profit sharing. In this regard, it is important to remember that the greater the functions, assets and risks, the higher the return. Even if the specialized service provider renders services of a different nature (e.g., information technology management or legal support), the transactional analysis requirement set forth in article 76-IX, b), c) and d) of the Mexican Income Tax Law would be in place, unless the scope of the services rendered and the distribution of risks between the contracting parties are adequately defined in a preliminary manner, which must be established contractually.
Speaking of contractual terms, taxpayers are required to formalize the specialized services contract before the Ministry of Labor and Social Welfare, as established in article 14 of the Federal Labor Law. Since this is a contract between related parties, in addition to the information required by the Federal Labor Law, the contract must observe the negotiation dynamics that would be agreed upon by independent third parties in comparable operations.
This includes an adequate description of the activities to be performed by the parties in compliance with the obligations assumed, the resources to be used and the risks to be assumed by each of them – in the understanding that the contracting parties have the economic capacity to face the eventual materialization of these risks, as suggested by the OECD transfer pricing guidelines in section 1.D.1. (It is necessary to make this clarification, because according to the Mexican Income Tax Law, the guidelines are considered for the interpretation of the transfer pricing regime in Mexico.)
Another important consideration is the recent criminal-tax reform approved in Mexico. Given that the reform seeks to punish absolute or relative simulation in the terms set forth in article 108 of the Federal Tax Code, it is necessary to confirm that the specialized service providers have the necessary experience, infrastructure, and resources to provide the service that will be part of their corporate purpose. In this sense, transfer pricing analysis will be of vital importance to assist taxpayers in the proper organization of their operations.
Last but not least, it is necessary to consider that in those cases in which employer substitution will not take place, and merger and spin-off operations are considered, it is foreseeable that there will be cases in which the disposal of shares will be necessary before arm’s length valuation of these operations, where the Comparable Uncontrolled Price method should also be considered as the best method for the analysis of this type of operations.
Concluding remarks
The reform will require significant efforts by taxpayers to comply with its requirements. It is understandable that taxpayers will focus on the labor and tax aspects. However, taxpayers must also comply with their transfer pricing obligations in due time and form, since the absence of transfer pricing documentation can lead to the loss of the deduction of the intercompany expense.
Moreover, if a taxable profit is determined, such profit would be considered a dividend, according to article 140-VI of the Income Tax Law. In addition, due to the mechanism provided in article 5 of the Valued Added Tax Law, the taxpayer would lose the possibility of crediting the value added tax associated with the intercompany items disallowed as a deduction for income tax purposes.
On the other hand, errors in the delineation of the transaction would lead to an eventual modification of the taxable income under the terms of articles 90 penultimate paragraph and 179 second paragraph of the Mexican Income Tax Law. In other words, if the taxpayer improperly assigns the business model, and this results in a lower taxable base, the taxpayer would be subject to a recharacterization of the transaction to reflect the prices and amounts of consideration that would have been considered by independent third parties. In the worst case, this could also lead to the application of the assumptions set forth in Article 5-A of the Federal Tax Code in the absence of a business reason, which would lead to criminal charges.