Brief tax alert on the possible effects in the reconfiguration of internal service provider (insourcings) company’s business structures from the initiative to reform subcontracting and outsourcing rules in Mexico.
Addressing the reform initiative to modify the rules on subcontracting and outsourcing presented the past December 12 by the Federal Executive to modify the Federal Labor Law, Social Security Law, Infonavit, Fiscal Code, Income Tax Law and Value Added Tax Law, there are various proposals being circulated to 1) transfer essential personnel to execute key business functions (primary functions) to operating companies, and 2)eventually concentrate support activities (specialized secondary services, as per terms from the Federal Labor Law) in a distinct entity.
In this particular case it is important to remember that taxpayers, for purposes to comply with transfer pricing regime as mandated by fractions IX and XII of article 76 of the Income Tax Law, must demonstrate that operations carried out with these companies will be agreed upon in terms and prices that would have been agreed upon among intendent third parties in comparable operations. In other words, that the services operations will be agreed in arm’s length terms, terms that are applicable even among operations with domestic related parties.
To present an example. If a potential specialized secondary services company provides services to a related party that concentrates the primary operating activities of the group, the return for the service provider (and eventually the profit partition to employees as required by the Law) will depend on at least the following factors:
1) The manner in which the operation is delineated. What type of services will be provided? What are the characteristics of said services? Under what business model?
2) The activities that will take place. What functions will be deployed (for example, administration, finance, human resources, IT, etc.)? What is the scope of the services? What is the frequency in the provision of the services?
3) The assets associated with the deployed functions. Are there intangibles involved or does this activity relate solely to routine functions?
4) The risks to be assumed between the parties. What risks exist in the operation and to whom are they going to be assigned? Does the entity that absorbs the risks have the resources to face their materialization?
The previous should consider the contractual terms agreed among the service provider and receiver, replicating at every moment the negotiation dynamic that would have been observed by independent third parties. Once concluded, arm’s length prices or margins must be attributed to each party as per the provisions of article 180 of the Income Tax Law in the order and hierarchy established by it. It is probable that these prices or margins may vary depending on the alternatives available to the taxpayer and the different business models it decides to implement.
From the point of view of the authorities and tax tribunals, lack of transfer pricing compliance documentation could lead to the dissalowance of intercompany expenses as deductions as they would consider that the taxpayer does not meet the requirements stated in articles 27 of the Mexican Income Tax Law in fractions V (deduction requirements for operations among related parties) and XVIII (term to meet the requirements established in the Law for each deduction in particular) In case that there is a taxable profit, said profit would be considered a fictitious dividend (LISR 140-VI). Finally, and as per the mechanism established in article 5 of the Value Added Tax Law, the taxable profit would lose the possibility to accredit the VAT associated to the disallowed intercompany accounts for Income Tax Law purposes. On the other hand, errors in the characterization of the operation would result in an eventual modification of the taxable base in the terms established by articles 90, penultimate paragraph, and 179, second paragraph, of the Income Tax Law. In other words, if the taxpayer incorrectly assigns the business model and this leads to a lower taxable base he would be subject to a recharacterization of the operations to reflect the prices and amounts that would have been agreed upon among independent third parties, or even, in the worst of cases, the application of article 5-A of the Fiscal Code of the Federation in the absence of a business motive.
