Significant Tax Savings Opportunity Available in Mexico With Principal Type Organizational Structure

The so-called principal or entrepreneur structure creates the potential for significant tax savings for multinational corporations with Mexican manufacturing operations. This system has been used within the European Union and now is being used in Mexico as well as other Latin American countries.

Jorge Gross, of PricewaterhouseCoopers in Miami, Florida, has worked extensively in analyzing the principal structure for its use in Mexico and throughout Latin America. In the following interview, Mr. Gross provides a general overview of the principal structure and offers some practical considerations for companies contemplating the use of the structure.

The interview was conduced by George Boerger for Strategies.

Strategies: What you are trying to accomplish with the entrepreneurial or principal type structure?

Mr. Gross: Effectively what you are trying to do is to reallocate income between jurisdictions. Through what is a tax-efficient structure you are trying to move income or profit from a high tax jurisdiction to a low tax jurisdiction via an arrangement that does not create tax problems in the Latin American country.

Strategies: Please describe a typical structure used in Mexico to accomplish the reallocation of income.

Mr. Gross: You have three parties: you have your principal, you have the manufacturer, and you have the commissionaire or commission agent. The principal or whatıs called sometimes the entrepreneur, is located in a low tax jurisdiction. Which jurisdiction that is will vary depending on the country that youıre dealing with. The principal is owned by a company that is located outside the country of the principal; typically in the United States. (See Diagram 1, page 10.)

Then generally what you have is a manufacturing facility that has been in a country other than the country where the principal is located for a long time and has basically been buying raw materials, transforming the raw materials into finished product and selling it in the local market. This manufacturing operation bears the full brunt of the local tax because it is basically selling the product directly to the customers. And the operation is selling it to the customers both within the local jurisdiction as well as in many cases exporting the product to other jurisdictions.

What we are doing then is that the principal or entrepreneur enters into a contract to effectively have that manufacturer, which was, for a lack of a better term, a full manufacturer or what I would call a buy-sell manufacturer and turns it into what is called a toll manufacturer. Toll manufacturing is a little different than contract manufacturing, although effectively it does the same thing, but the reason why it is different, is that in the toll manufacturing arrangement, the raw materials are purchased by the principal, which in this case is located in a low tax jurisdiction. The raw materials are given to the manufacturing facility which transforms them into a finished product for a service fee and the product, throughout the entire transformation chain, is owned by the principal, not by the manufacturing facility. The manufacturing facility now is turned into purely a service provider that, in effect, all it does is that under specifications of the principal transforms the raw materials into a finished product.

Strategies: Why is the principal generally located in a low tax jurisdiction?

Mr. Gross: The principal is generally located in a low tax jurisdiction because the principal is where the vast majority of the profits for the transaction are going to reside. And the reason for that is, that under transfer pricing rules, the risk on this transaction has been shifted from the manufacturer to the principal. Because the principal owns the raw material it basically bears the entire risk of obsolesce, warranty, everything else throughout the entire transformation process. In contrast, before the manufacturer purchased the raw materials and transformed them. Thus, the manufacturer was bearing the risk and the manufacturer was entitled to the majority of the profits. So by having the principal bear the risks for the manufacturing operation and thereby shifting profits to the low tax jurisdiction of the principal, weıve got a much more tax efficient structure.

Strategies: Under the principal structure how is distribution of the product handled?

Mr. Gross: The distribution is the third step in the typical principal structure and is handled by way of the commissionaire. Now in a true commissionaire arrangement, a true commissionaire sells product on a commission basis on behalf of the principal, but in its own name. So it is basically selling the product in its own name but on behalf of the principal because the principal is the one who has title. In many countries in Latin America, that is not possible because that concept is not known. So effectively in a lot of Latin American countries what you end up having is a commissionaire arrangement where the ultimate sale of the product takes place via a commission agent or sometimes through what is called flash sales, which is a sale of the product to the commissionaire, who immediately transfers title to the ultimate customer, but all of the risk for the sale remains with the principal and not with the commissionaire.

Strategies: How have companies with operations in Mexico used the principal structure to their advantage?

Mr. Gross: Mexico is one of the few countries in Latin America where you can do this kind of structure. Now it is even getting harder to accomplish in Mexico for several reasons. One of the key ingredients with the principal structure is that you have got to prevent at all points in time the Mexican tax authorities from saying that your principal has a permanent establishment in Mexico. If the Mexican tax authorities can successfully argue that your principal has a permanent establishment in Mexico, then you havenıt achieved anything because you have brought back into Mexico for taxation all of the profits that you were trying take out of Mexico to a lower tax jurisdiction. So one of the key ingredient is making sure that your principal does not have a permanent establishment in Mexico.

The other thing is that you have got to be absolutely sure that your payments to your toll manufacturer and to your commission agent are at armıs length because you have transfer pricing rules in Mexico. You have to make sure the payments to your toll manufacturers and commissionaires are made appropriately on an armıs length basis so that you donıt run afoul of the transfer pricing legislation.

Strategies: Are there any specific types of manufacturing companies that seem to benefit the most from this type of structure?

Mr. Gross: I would say that any type of consumer and industrial products companies, anybody whoıs got heavy manufacturing should consider the principal structure, especially if they are exporting out of Mexico or some other jurisdiction. The principal structure works the best when you have manufacturing in a local jurisdiction and the company is making significant exports.

Strategies: What countries are generally chosen for the location of the principals?

Mr. Gross: Several. Certainly Switzerland and certain other countries in Europe have been selected. Puerto Rico has been an alternative as well as Uruguay and Costa Rica have been looked at. There are an awful lot of different issues that you need to address. On of the most significant being permanent establishment; do you have treaty protection that would allow the principal to have a clear definition of what constitutes a permanent establishment and therefore have the principal taxed in the local low tax country.

Strategies: Other than low or no taxes, what are some of the other factors you examine when determining the location for the principal?

Mr. Gross: You would look at treaties that are in effect, you would look at the jurisdiction itself because youıve got to have substance in the principal. This is not a paper transaction. The principal has got to have sufficient substance for this kind of transaction to be successful. If it is purely a paper transaction, where it is almost no substance to the principal, this is not going to work, nor is it going to be respected.

Strategies: Although youıve touched on this earlier, could you describe in more detail how the toll or contract manufacturers operate under this structure?

Mr. Gross: The toll manufacturer, the true toll manufacturer, never owns the product. Never owns the raw materials, never owns the finished product, it purely provides a service, and that is converting raw materials into a finished product under the specifications of the principal. A contract manufacturer is a little different. A contract manufacturer buys the raw materials and turns them into a finished product that belongs to the principal. In a contract manufacturing facility, the principal goes to the contract manufacturer and orders the product according to certain specifications. The contract manufacturer buys the raw materials and turns them into a finished product that is sold to the principal.

Strategies: When you have an existing company with manufacturing facilities in Mexico that is trying to implement the principal structure what issues do you examine?

Mr. Gross: There are a couple of issues that need to be addressed and that is whether or not when you convert a full-fledged manufacturer into a toll manufacturing arrangement do you have a transfer of goodwill? The potential transfer of goodwill creates possible tax issues, both in the local jurisdiction and in the U.S. if there is U.S. parent. For example, if you take a company that was making X dollars, and the following year, it is making substantially less than X dollars because you have sucked a lot of that profit out into a lower tax jurisdiction, have you had some type of transfer of goodwill? Have you in effect transferred a profit stream from one location to another location and what are the tax implications of that? These are very complicated issues that need to be dealt with on a jurisdiction-by-jurisdiction basis.

Strategies: Are there any advantages in operating a toll or contract manufacturing operation in Mexico compared to the rest of Latin America?

Mr. Gross: Well, it depends. The reason why I say it depends is Mexico I would say by far and away is the country in Latin America that has come up the fastest toward tax sophistication. It has in the last couple of years transformed its tax system into a fairly sophisticated tax system, very much like most developed countries of the world, certainly very much like the U.S. So you need to view Mexico with the complexities that normally arise as a result of a sophisticated tax system. On the other side, with sophistication comes a little bit more certainty as to what the tax results are. So itıs a double-edged sword. On the one side, you may get more certainty. On the other side, it may make the implementation of structures such as this a lot more complicated.

Strategies: Have you seen contract manufacturing used quite a bit in Mexico?

Mr. Gross: Yes, we first saw it in vast quantities in the maquiladora programs, where the machinery, equipment, raw materials and everything were basically owned by the U.S. company. The raw materials were shipped to a manufacturing facility close to the border where they were transformed to a finished product and re-imported back into the U.S. Under old legislation you were able to leave very little profit in Mexico with respect to this. There have been some changes to that program that makes it a little bit less attractive, but nevertheless, it is still being widely used.

Strategies: How are the transfer pricing issues being addressed by the Mexican authorities?

Mr. Gross: Mexico has had transfer pricing rules for several years. Mexico has a team of transfer pricing specialists trained in the U.S. Mexico was the first country in Latin America to have transfer pricing legislation so it is far ahead of the curve as far as Latin American countries are concerned and is very aggressively pursuing transfer pricing audits on a lot of clients. The Mexican authorities realize that transfer pricing is a big issue, it is very big in international taxation and Mexico is very good at it.

Strategies: When examining companies operating in Mexico for possible implementation of the principal structure what do you look for?

Mr. Gross: Again, it depends on the company because probably the longer a company has been in a location, whether it be Mexico or another Latin American country, probably the more tax inefficient structure it has. And the reason is because they were probably structures that were put in place back in the days where legislation, not only in Mexico, but the rest of Latin America, was substantially different. A lot more complicated. So what you find is that particularly, you would have in many cases a manufacturing facility and also a distributor where manufacturing did all the manufacturing, sold the product to the distributor who then distributed to all of the different third party buyers or retailers.

Strategies: What have you observed companies doing today when locating manufacturing facilities in Latin America?

Mr. Gross: If companies are going to have a full-fledged manufacturing facility that is going to bear the majority of the profit because it bears the majority of the risk, they are trying to locate those in low tax jurisdictions, not high tax jurisdictions. So in many cases, manufacturing facilities are being located in places other than Mexico, although Mexico is still attractive because it has low labor costs and a large population, skilled labor and so on and so forth.

Strategies: What is a stripped-risk buy-sell distributor and how does that arrangement work?

Mr. Gross: Stripped-risk buy-sell is where you are actually selling the product to a distributor in the local jurisdiction. In many cases, your own distributor. Letıs say, for example, it could be your commissionaire. That, rather than paying them on a commission basis for whatever reasons, and sometimes those reasons have to do with local jurisdiction and a prohibition on having a commission structure in place, the principal sells them the product. However, the seller retains the vast majority of the risk on that sale until it is sold to a third party. So, letıs say I sell you a product and I retain the risk of the warranty, I retain the risk of obsolescence of inventory, of anything that has to do with the product, I retain that risk, so that even though you have taken title to the goods, you are acting almost like a commission agent.

Strategies: By retention of risk the principal is therefore able to retain a larger percentage of the profits?

Mr. Gross: Yes, thatıs correct. The use of the stripped-risk buy-sell distributor also has a lot to do with VAT. There is an input and an output VAT so technically it should be zero cost to a seller, because heıs paying VAT but heıs also collecting VAT from the ultimate buyer. Sometimes when you have cross-border transactions, you get caught in situations where you have unrecoverable VAT.

Strategies: What issues do customs duties raise on goods imported into Mexico?

Mr. Gross: One is the unrecoverable VAT issue. Another issue would be whether the company is allowed to bring a product in and not pay the import duties and everything else if the company is going to re-export the product. The answer to this question is yes a company should be able to do that. There are a number of programs in Mexico, temporary import licenses and some others that will allow companies in many cases to bring in the raw materials and transform them and bring them back out without necessarily paying up-front all of the import duties and everything else that goes along with it.

Strategies: What trade agreements that Mexico has entered into have the most impact on the use of this principal structure?

Mr. Gross: Definitely NAFTA. Mexico has a number of trade agreements. Iım not familiar with all of them. I do know that it has one with Chile. We have our customs group that generally looks at the impact of trade agreements.

Strategies: What are the most important areas of review that you go over when considering if the principal structure should be used by a particular company?

Mr. Gross: Well, first of all, you are talking about a major transformation with respect to a company and it impacts not only tax, it impacts almost every aspect of the company, not only from an operations perspective. It impacts information technology systems and the way that you report sales. It impacts human resources in the sense that if you have letıs say a country manager whose performance measurements are being based on the profitability of operations in a country. With the implementation of a principal structure now all of a sudden you are taking a lot of the profit out of the country. With this change there has got to somehow be change made to the way that you are measuring that individual because profitability is out of his control. You are also talking about changing management in the sense that you are going to be operating in a very different way than you were operating before. So it is a major transformation, it does involve many different aspects of the company and these types of arrangements have to have complete buy-in at the highest levels of the company.

Strategies: When operating the principal structure in Mexico what are the biggest areas of concern?

Mr. Gross: The issues of permanent establishment of the principal, the issues of the potential transfer of goodwill and making sure the transfer pricing legislation is respected.

Strategies: How would you summarize the potential use of the principal structure?

Mr. Gross: The principal structure is being widely considered. It can be very tax-efficient and thus very beneficial. You are not talking about small projects here. You are talking about projects where you have got to have buy-in at the very high levels of management in a company for this thing to be successful. The high level buy-in is needed because you do encounter an awful lot of resistance especially from the people in the local jurisdictions and at the lower levels whose slice is being impacted by a very major change.

Strategies: Finally, in addition to the use of the principal structure cross-border loans can be used to obtain tax benefits. What are the most significant issues in Mexico with respect to the cross-border loans?

Mr. Gross: First of all, treaty jurisdictions, thatıs essential. Making sure that the loans are respected as loans. You also have, although I think itıs going away now, very different withholding rates for financial institutions, financing versus straight related-party financing. If you have related-party financing, then you bring transfer pricing into it, making sure that youıve got proper armıs length interest rate. And also the fact that there are structures that can be put together in Mexico and many other countries in Latin America that would give you two deductions for the same amount of interest, what are called double-dips.

Strategies: How do the double-dips work?

Mr. Gross: Itıs basically using what are called hybrid instruments and hybrid entities. Hybrid instruments and hybrid entities mean they are a hybrid in the sense that they are one thing in one jurisdiction and something else in another jurisdiction. So you would have, letıs say, an instrument that would be respected as a loan in Mexico, but itıs really capital for U.S. purposes, so it carries two different tax results in each jurisdiction. Then you have to use what are called hybrid entities in the sense that these are entities on the new check-the-box regulations, are treated as flow-through entities for U.S. purposes, but are respected as corporations in the local jurisdiction. So by basically mixing jurisdictions and the way that each jurisdiction interprets an instrument or a company, you can achieve some very interesting results.

Conclusions

The use of the principal structure presents a potential method by which a companyıs tax liability can be significantly reduced. If your company is engaged in manufacturing operations in Mexico or elsewhere in Latin America and a significant potion of the finished goods are exported, you should closely examine the principal structure. As Mr. Gross has explained, although there are significant tax savings available it is imperative that the complicated issues be examined and that any resulting organizational change to implement the principal structure have substance to successfully defend any challenge by local tax authorities.

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