Mexico’s tax reforms: opportunities and obstacles

Mexico is shaking up its tax system, by increasing corporate tax and retail sales taxes, among others. Selwyn Parker looks at the effects this might have

Mexico workers
Workers at a cross-border plant in Mexico's Chihuahua state. Taxes are being raised on many factories of this kind  
Author: Selwyn Parker
January 21, 2014

Congregated along Mexico’s border with America are hundreds of factories known as maquiladoras, or assembly plants. Mostly foreign and in particular American-owned, they export their products under long-standing, favourable tax arrangements that have contributed greatly to Mexico’s economy.

According to Mexican research institute Colegio de la Frontera Norte, the maquiladoras account for 60 percent of all jobs provided along the frontier states. And in Mexico as a whole, the factories’ contribution to the economy is second only to that of oil giant Pemex, easily the biggest business in the country. The more than 5,000 maquiladoras in Mexico provide 1.9 million jobs, estimates the Congressional Research Office.

As Richard Rubin, a local businessman associated with the factories, told the Christian Science Monitor, “Mexico would be crazy to destroy the maquila [assembly] industry.”

Stormy passage
But that may be an unwanted consequence of a tax package that was voted through congress in late 2013 after a stormy passage that saw the opposition walk out in protest because, it warned, the measures would damage the economy. The wide-ranging changes affect most sectors, from finance and the stock market to retailers and manufacturing. The financial sector, for example, will be hit by new rules on write-offs for bad debt.

Withholding taxes

Most countries apply withholding tax to dividends paid on securities, such as shares held by non-residents. In most years they collect around $3.7bn – but most of these nations also give it back under bilateral arrangements known as income tax treaties negotiated between governments.

The right to make a claim – or rather, a reclaim – arises because the rate applied under these treaties is generally lower than the default withholding rate, normally around 15 percent, fixed by most foreign governments. Some countries charge more, such as Brazil and India, who withhold 25 percent. The five-star location for foreign investors is the UK, which allows 100 percent reclaims on investments made in British companies.

But things are not always how they seem. Differing national regulations can result in higher or lower reclaims than expected. For instance, under Canada’s tax treaty with Israel, the rate is 15 percent, while withholding tax on divvies issued by Israeli companies is 20 percent. So Canadian investors in Israeli companies should get back five percent? Wrong. They generally recover 11 percent because the actual rate works out at nine percent. This is one reason why foreign investors in Mexico should work through international accountants.

From January, banks are permitted to deduct these for tax purposes only after they are legally defined as uncollectable. And that can happen only when the government, in the form of the National Banking and Securities Commission, issues a specific authorisation.

In an attempt to increase the taxable income available to it, the government has also dragged insurance companies into the net. Until now, these firms have been allowed to create and deduct so-called technical reserves accumulated for risk, actuarial and other purposes, as Ernst & Young points out. But henceforth deductions will be accepted only for actual and verifiable losses.

Of huge importance to so-called ‘bird-in-the-hand’ investors are new measures on withholding taxes. These comprise a 10 percent tax on dividend payments and distribution of profits by Mexican companies. Some consultants have pointed out that, because the distributing company will henceforth be defined as the taxpayer, this could effectively sideline cross-border tax treaties that normally allow shareholders to claim deductions.

And accountancy firms are still trying to figure out the implications of the regulations on payments to related parties – but it will certainly hit them in the wallet. “This is a very broad rule that would appear to require that the taxable base of a non-resident recipient of income from Mexico [must] be calculated based on Mexican rules,” suggests Ernst & Young. Loopholes will be hard to find.

And finally, there will be a tax on stock market gains. The current exemption on the sale of publicly traded shares will be axed and replaced with a 10 percent impost. Whatever the full implications turn out to be, the combined rules are certain to make ‘bird in the hand’ investors – those who prefer to take their gains in regular dividends rather than wait for capital gains – think twice about putting their money into big listed companies.

Changing rates
Meantime, the maquiladoras are weighing their options. All of them will lose some of the preferential tax breaks that first brought them here in the 60s. First, they will have to pay a new 16 percent sales tax on all goods imported for assembly prior to export.

Although the tax, which is designed to thwart tax cheats, is reimbursable, it will certainly have an effect on cash flow. Second, retail sales tax – long fixed at 11 percent to attract business from Arizona, Texas, New Mexico and other US border states – will increase to 16 percent in line with the rest of the country. And for good measure they will also be hit by a Mexico-wide hike in corporate tax from 17.5 percent to 30 percent.

Fortunately dropped from the package were plans for a second import tax on the factories. However, some factory owners are still threatening to shut down their businesses and go elsewhere.

The country’s tax system is chronically top-heavy

It is not hard to understand President Enrique Pena Nieto’s dilemma. His most pressing economic problem is Mexico’s low tax take, in fact the lowest by some margin of all 34 OECD member countries. The total tax revenues at his disposal amount to just 19 percent of GDP. By comparison, the ratio for Greece, notorious for tax evasion, stands at 31 percent. As the OECD points out, the country needs to widen its tax base to provide the health, infrastructure and social projects considered essential to improve the quality of life of Mexico’s 120 million people.

But the reforms will fall far short, says Mexico-watchers who say the tax take has to increase by three or four percent to achieve what is needed. “Representing barely a one percent additional share of fiscal revenue, [the package] will be insufficient to begin the process of weaning the government off Pemex’s revenues”, points out Andres Rozental of American think-tank the Brookings Institution.

The problem with Pemex
The country’s tax system is chronically top-heavy. Governments have relied for years on Pemex, the state-owned oil giant with 2012 revenues of $128.7bn, to keep the country’s accounts topped up. Indeed, Mexico has shamelessly milked the energy company’s profits. As the University of Pennsylvania’s Wharton business school points out, “Pemex pays out more than 60 percent of its revenues in royalties and taxes to the government, providing some 30 percent of total tax revenues”.

No wonder the company loses money despite its vast revenues. Pemex forks out four times as much in taxes as it invests, adds EMPRA, a Mexico City-based consultancy specialising in emerging markets.

While all three main political parties agree something must change, nothing will happen overnight in what is a highly political issue

It could be though that these reforms are tackling Mexico’s tax problems the wrong way round, say economists. Take, for example, the underground economy. Like other countries in the region, Mexico has a high level of informal labour that falls outside the tax net. If the government were to find ways of gathering these wages, the tax take would increase substantially.

Then there is Pemex itself. An infamously poor performer among international energy giants, it produces less oil now than it did a decade ago. Projected production for 2013 is approximately 2.5 million barrels, compared with 3.4 million in 2004. Meantime, other oil-rich countries such as Colombia and Brazil have doubled and tripled production. The problem? “Mexico has one of the world’s most closed oil and gas sectors,” explains Duncan Wood, Mexico specialist at Washington DC-based research institute the Woodrow Wilson Centre.

Oil workers in Mexico
Derrick hands working on a Pemex exploration oil rig. Mexico has long been reliant on the nationalised oil giant for income

While all three main political parties agree something must change, nothing will happen overnight in what is a highly political issue. Mexicans see Pemex as an almost untouchable national asset whose nationalisation in 1938 – the year foreign oil companies were kicked out – marked a turning point in the nation’s sovereignty. “The Mexican government wants to maintain control of the commercialisation of the oil for political reasons,” adds Wood.

The overall package barely merits a pass from most consultants. “The main fault is that it does almost nothing to widen the taxpayer base,” concludes the Brookings Institute’s Andrés Rozental, pointing out that it targets a capital middle class that already pays taxes and corporations that will only pass their costs on to consumers. Once again it seems Mexico will fail to amass the taxes due a country of its size.