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Mexico Taxes: Breaking the Code [Global Business magazine]

by Hope Katz Gibbs
Contributing Editor
Global Business magazine
September 2000

MEXICAN ELECTORAL OFFICIALS HAD BARELY finished tallying up the votes late in the night of July 2 when executives across Mexico began a different sort of calculation—as they prepared to ask President-elect Vicente Fox for tax breaks and other pro-business measures.

Few in the business community had bet beforehand that Fox would be able to end the 71-year rule of Mexico’s Institutional Revolutionary Party. Yet most quickly grasped the significance of the fact that a businessman—rather than a career politician —would set the economic tone for the
next six years.

“Because Mr. Fox comes from the private sector, he knows how painful the tax system is,” says Mauricio Monroy, tax partner at the Deloitte & Touche office in Mexico City. “Mexico has burdensome rules and a high tax rate that doesn’t promote investment at all.”

Pushing such reforms won’t be easy for the former executive of the Coca-Cola company in Mexico. For one, the ranks of potential ministers from within Fox’s National Action Party are thin. Then there will be Fox’s need to form alliances with members of the ousted PRI or perhaps with the more leftist Party of the Democratic Revolution (PRD). Another potential problem lies in Mexico’s five-month transition period, which in the past has led to dangerous power vacuums.

Perhaps the biggest obstacle to any major cuts will be the difficulty Fox will face in raising money elsewhere. A proposal to tax food and drug consumption, floated in early August, was widely attacked as an assault on Mexico’s poor.

Yet for the time being, the investors appear very enthusiastic about the vote. “The market is seeing Fox as a man who can bring important changes, in the sense of modernizing the economy and the system,” Rogelio Ramfrez de la O, president of Ecanal, a Mexico City consulting firm, told reporters recently.

UP AND UP

When it comes to business taxes, it is not Mexico’s corporate rate itself that distresses executives. Since NAFTA was enacted in 1993, the tax has actually been very similar to the U.S. corporate rate, and now stands at 35%, 5% of which can be deferred if the income is reinvested in the Mexico-based portion of the business.

“What makes doing business in Mexico complicated is the fact that in recent years Mexico has been collecting more taxes, making it harder and more expensive to do business there,” says tax attorney John McLees, a partner in the Latin American Practice Group of Baker & McKenzie in Chicago. “That is the increasing concern for foreign firms.”

The real problem is not so much that the Mexican government has created new taxes, as that authorities there so often ratchet up the tax code to generate new revenue.

“Every single year for the last five years, changes have been made to the tax system in Mexico,” Monroy says. “Additionally, every month the Mexican Treasury issues corrections to rules and sometimes we see corrections to the corrections.”

Among the most controversial of the tax change involved the Asset Tax, which requires companies to pay a minimum of 1.8% per year on the value of both fixed and financial assets, regardless of whether the company earned any profits in a particular year.

Other taxes that have been much mom onerous in recent years include Mexico’s real estate transfer tax, which ranges from 2% to 4%, the payroll tax on employees’ salaries that now runs at 9%, and a withholding tax that now stands at 7.7%. There have also been changes in Mexico*s employee profit sharing rules and now in how much companies must contribute to the social security tax.

Add to this the government’s new-found interest in enforcing its transfer tax regime, as well as a more robust enforcement of its 15% Value Added Tax on the sale of goods and services, and it is easy to understand why taxes have become topic number one for many foreign-owned businesses in the country.

Most debates don’t focus so much on the validity of the Mexican state’s need for revenue—a drive down most Mexican highways quickly confirms that a vast amount of work remains to be done—as it is about the regime’s complexity and lack of predictability.

“This is a tough system to comply with because foreign companies have trouble keeping track of every tax that needs to be paid,” Monroy says.

SINKING PROFITS

One of those frustrated with the system is Richard Sinkin, managing director of InterAmerican Holdings, Co, a consulting and investment firm with offices in San Diego and Mexico City. InterAmerican has managed the start-up of 26 manufacturing plants in Mexico since 1987, and for the past two years has operated an automotive engine plant in Gomez Palacio, in North Central Mexico.

“Mexico’s tax system is the most mind-numbing, complicated thing a company doing business with Mexico has to deal with,” Sinkin says. “It is based on high inflation and old-fashioned accounting rules. Everything needs to be shaken up. Mexico definitely needs a more modern tax regime.”

In fact, Sinkin says the recent changes in the Value Added Tax and the asset tax may cost Industrias de Linamar an important line of business with Renault, for which the company manufactures 600 engines per day. In this case, the problem is with how Industrias de Linamar’s hard assets will be taxed. The plant, owned by a Canadian holding company, has received about $35 million in new manufacturing equipment in recent years without having paid any taxes on it.

Technically, Sinkin says, the equipment has simply been “stored” at the Mexican plant until its “owner” requests that it be returned. Consequently, Industrias de Linamar has a huge amount of assets on its books—assets that now require taxes to be paid.

When the tax man cometh, Sinkin says the company will have to raise its prices. And that could be a deal breaker with Renault, he says.

“The question you need to ask yourself is what kind of assets should you hold,” Sinkin says. “We’ve had to start rethinking how we do business in Mexico.”

Sinkin is not alone.

“Companies are in a tough position regarding their equipment and real estate holdings,” says Nick Criss, director of industrial services for Cushman & Wakefield in San Diego. “The asset tax has changed everything, especially with regard to real estate.”

Criss says that companies operating in Mexico have traditionally tried to own the buildings they use, especially the plants that would house their core manufacturing facilities. Companies might be willing to lease the peripherals—such as sales and marketing offices—but most wanted to make sure they couldn’t be evicted from key sites.

Now that real estate is a taxable asset, however, Criss says that most foreign firms are starting to lease property to save money. “Some companies want to sell what they have and lease back the properties so they don’t have to pay taxes on it,” he says.

For the time being, companies can only hope for some relief, Criss says. “We’re in a waiting period now. Everything regarding taxes, and how best to deal with them, could change in the next few months.”

Sinkin tends to be more pessimistic. “All the loopholes that made it profitable to do business in Mexico are being taken away,” he says.

RELATIVELY SPEAKING

As confusing as the situation may have become over the last few years, Monroy says it is important to remember how many improvements have been made.

“Prior to NAFTA, the international tax provisions of the Mexican tax system were in harmony with the then protectionist environment of Mexican trade,” Monroy says, in one of the more polite comments about that regime.

The system was characterized by high withholding taxes on the repatriation of profits, frequently at 21% to 35%, and high duties on the importation of goods, he says. “It wan not abnormal to find duties of 100% ad valorem.”

At that time, he adds, the Mexican government was generally reluctant to enter into tax treaties that prevent double taxation, due to the notion that such treaties eroded the tax base.

Of course, Monroy says, the goal at the time was pretty much the opposite of today’s tax regime. Through the late 1980s, Mexico saw its tax regime as a major way to protect locally owned businesses, and used it to actively inhibit most investment from abroad, he says.

In some ways, the problems with today’s tax regime in Mexico are that in many ways, it is a direct outgrowth of the protectionist system of the 1980s, Monroy says.

When Mexico began to change its tax laws to harmonize with NAFTA, the government didn’t rewrite its laws entirely, preferring rather to try to make the old ones work in the new free trade environment.

“It would have been easier in 1993 to throw away old laws and invent new ones, but for political reasons the government chose to patch old laws,” says Monroy. “The result is what we have today—a messy tax system.”

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"I get by with a little help from my friends," says Hope, who gives special thanks to:

• MICHAEL GIBBS, website illustration and design: www.michaelgibbs.com
• MAX KUKOY, website development: www.maxwebworks.com
• STEVE BARRETT, portrait of Hope on Bio page: www.stevebarrettphotography.com

Contact HOPE KATZ GIBBS by phone [703-346-6975] or email.

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