In Mexico there are many companies engaged in rendering personnel, administrative or specialized services. These services could be provided by related or unrelated parties within a multinational Group. The most common services include provision of administrative (accounting, tax, legal, financial, human resources, among others), IT, marketing, technical and manufacturing services.
Operating companies hired services from these service providers. Such service structures, as they are commonly referred to, were a business strategy for operating entities, since personnel, legal, social security, among other risks related to hiring directly their personnel was relieved, given that the personnel were hired directly by service companies that rendered the required activities or services, therefore, assuming the burden arising from the labor perspective.
Employees in Mexico, as a constitutional right, are entitled to a 10% of the profits of the Company that hires them (the Employer), this is defined as the employee profit sharing (commonly known as PTU per its acronym in Spanish). This PTU obligation is calculated on a pre-tax income of the hiring company as stated by the Mexican Income Tax law (MITL).
In this sense, employees hired by a service company computed the PTU based on the pre-tax income of the service company, and not the operating entity or any other company of the Group.
In general, the provision of these services establishes a consideration that could be analyzed on a cost-plus basis. This is the service company charges a consideration that includes all costs and expenses incurred in the provision of services, plus a profit markup. This consideration could be determined as a variable fee, a fix fee or a direct cost-plus consideration, which could be charged monthly, quarterly, etc. Considering this compensation scheme, it is implied that the PTU obligation which is an operating expense by means of the applicable Financial Reporting Standards in Mexico (NIFs per is acronym in Spanish), was part of the fee charged by the service company to the operating entity.
As it may be understood, multinational groups operating in Mexico more likely have related party transactions that involve the rendering of personnel services.
Mexican labor and tax reform
On April 23, 2021, a Labor and Tax Reform was published in the Mexican Official Gazette, with a general entry into force on April 24, 2021, except for certain provisions, such as tax provisions, which will enter into force on August 1st, 2021. This reform is commonly known as the “Outsourcing Reform”.
As a result of such reform, provisions for labor outsourcing regime were repealed and, under these new provisions those structures are specifically prohibited. Outsourcing is referred as the subcontracting of personnel.
Operating entities will be required to hire the personnel to carry out their core business activities and/or the activities included in their corporate purposes as per their bylaws.
As a result of this Outsourcing Reform, services structures should be discontinued or restructured, otherwise all entities involved will be at risk of carrying out activities which are now prohibited from a labor and tax perspective.
In general terms, under the new legislation the outsourcing of personnel is defined as cases where an individual or legal entity provides or makes available its own employees for the benefit of another individual or entity.
As an exception, employment agencies that intervene in the hiring process of personnel may continue to participate in the recruitment, selection, and training of personnel, since they would not be considered as employers, given that such capacity is held by the individual/entity who benefits from the services provided.
The Outsourcing Reform establishes that specialized services or execution of specialized works that are not part of the corporate purpose or main economic activity of the beneficiary (operating entity) are allowed as an exception. There are some requirements to be met by these specialized companies, including the registration before the Ministry of Labor and Social Welfare.
For services provided by related parties, complementary or shared services (such as back-office activities) could be considered as specialized, considering the concept of business group as established in Mexican legislations. In this sense, related parties could implement an updated service structure that only considers the provision of specialized services and/or execution of specialized works as established in the Outsourcing Reform, which could be related to IT, surveillance and security, cleaning, among other services.
For all cases, the related parties should perform a detailed functional analysis regarding the allowed rendering of services to determine the applicable arm’s length consideration, based on the functions performed, assets used, and risks assumed by the entities involved.
The review of transactions that include the rendering of services is of the highest priority, since entities that carry out the now prohibited outsourcing of personnel or services without the corresponding registration, will be fined with amounts calculated as 2,000 to 50,000 times the value of the Unit of Measurement and Update (approximately between $9,000 and $225,000 USD).
Additionally, companies would face the non-deduction of expenses associated with the outsourcing services or the non-creditability of the VAT and, in an extreme case, these services could be qualified as a tax fraud that could derive in a criminal act.
Given the scope of this Outsourcing Reform, in addition to labor and tax matters, implications for areas such as social security contributions, transfer pricing, corporate, among others, could be generated thus, in all cases, the compliance of this Outsourcing Reform should be handled under an all-inclusive approach.
Alternatives for trying to comply with the new provisions may consider the employer substitution scheme, through which the operating entity would assume all labor and employee benefit obligations as the new employer; or a restructuring in which the operating and the service company could be merged.
Transfer pricing considerations
The effects of this Outsourcing Reform encompass different areas, including transfer pricing as a very significant matter. Considering the employer substitution scheme, a common controversy is related with the transfer of employees from the service company to the operating entity, specifically analyzing if a consideration should be applicable between both parties.
The outcome might change derived from the specific characteristics and circumstances of the service structure, including personnel involved, service provided, and the possibility of intangibles being transferred as part of the transaction (know-how, intellectual property, formulas, among others). Therefore, a transfer pricing analysis should be performed regarding the pre and post restructuring position of the entities involved.
In addition, there may be labor liabilities generated by the services entity that should be analyzed in this restructure, and these items should also be considered in the transfer pricing analysis.
As stated in the MITL, taxpayers that undertake transactions with related parties, are required to determine their income and deductions considering the prices that would have been used in comparable transactions between independent parties. Furthermore, as part of the transfer pricing provisions included in the MITL, it is established that as a source for interpretation regarding transfer pricing issues, the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”) will be applicable.
There are no specific provisions in the MITL regarding the transfer of employees from a transfer pricing standpoint, therefore, this item should be reviewed considering the OECD Guidelines.
It is also advisable to review the intercompany agreements to determine if the transfer of personnel or the ceasing of the services provision, could activate “termination clauses” that could trigger additional effects.
Other item to be reviewed is the PTU obligation for entities directly hiring new employees. In general, an increase in expenses of the operating companies derived from the PTU obligation should be expected.
This effect would have an impact on transfer pricing matters since the PTU obligation is considered an expense for financial purposes, thus this PTU obligation will adjust the profit level indicators (PLI) of the operating entity for purposes of testing the arm’s length principle.
On the other hand, the effect of the profit markup used to be charged by service providers to the operating entities would no longer be applicable, therefore causing a decrease of the expenses of the operating entities.
A complete transfer pricing analysis, functional and economic, should be carried out to determine the applicable PLI of the operating entity, as well as the financial effect of the new PTU obligation effect versus the previously paid service markup.
The approved Outsourcing Reform implies several relevant factors and effects in different matters (labor, tax, transfer pricing, social security, corporate, among others) that should be assessed for every specific case, preferably through a holistic approach, to minimize all possible liabilities and contingencies that could be generated to all entities affected by the rendering of services.
Regarding transfer pricing, in every case a thorough functional and economic analysis, should be elaborated to properly evaluate the pre and post restructuring positions of the companies involved in order to establish the corresponding arm’s length compensations