The Qualified Maquiladora Approach Agreement has been renewed: Implications for multinationals' transfer pricing

The influence of the OECD’s Base Erosion and Profit Shifting framework in today's global economy is undeniable, as is the inspiration it has provided to tax authorities around the globe.

In the area of transfer pricing (TP), tax authorities in jurisdictions around the world are continuously increasing their audit activities as they seek to ensure that multinationals are appropriately attributing their profits. In many cases, the expected tax burden for businesses has significantly increased. Multinationals are seeking tools that will provide certainty about the applicable TP methodology. The Advance Pricing Agreement (APA) is one of the most frequently utilized procedures in this regard.

A very common structure relying on TP considerations is the Mexican maquiladora. The maquiladora is a result of an agreement between the governments of the United States and Mexico in the 1960s to make investments in the manufacturing sector in Mexico more attractive. Since then, the two countries have crafted a series of agreements to refine and improve the maquiladora, including a framework agreement to avoid double taxation which resulted in the creation of a Qualified Maquiladora Approach Agreement (QMA) in 2016.

The QMA has now been renewed, and the US Internal Revenue Service (IRS) recently published an announcement addressing its key elements.

Here is what we know about the agreement and how it might impact maquiladoras.

What is a maquiladora?

A maquiladora is a manufacturing operation or factory in Mexico, usually near the US-Mexico border, that acquires raw and/or semi-finished materials from a foreign principal and manufactures or assembles a finished product, which will then be exported back to the principal. The owner – the maquiladora principal – is usually located in the United States. Essentially, the maquiladora provides manufacturing services to its principal, and the foreign principal is the owner of the inventory, machinery and equipment.

Besides the economic advantages of competitive manufacturing costs, maquiladoras have significant tax advantages, in particular a statutory permanent establishment (PE) exemption. Under this exemption, a maquiladora does not constitute a PE for Mexican tax purposes, and corporate income taxes are essentially based on a small percentage of the production capital (total value of the assets or cost and expenses). In addition, there are significant duty and tariff exemptions in both Mexico and the US, as well as substantial VAT benefits, payroll tax and social security benefits, and overall TP certainty for manufacturing operations through safe harbor or APA.

Agreements between the US and Mexico concerning maquiladora activities

In 1999, the US and Mexican competent authorities (SAT) reached an agreement on TP and other aspects of the tax treatment of maquiladoras of US multinational enterprises.

In 2016, both authorities renewed the agreement, updating and expanding upon the 1999 agreement in order to reflect revisions to Mexican domestic tax rules governing TP, documentation requirements and other tax attributes of maquiladoras. Within the renewal, several changes relating to TP were implemented. However, taxpayers with unilateral APAs pending already could elect to apply the newly introduced TP framework in accordance with the 2016 agreement, or they could choose to apply the safe harbor provided by the 1999 agreement. As a third alternative, the unilateral APA could be transformed into a request for a bilateral APA with the US and Mexican competent authorities.

Because the TP framework implemented with the 2016 agreement was discussed and agreed upon with the US competent authority in advance, the TP results set forth in unilateral APAs under this framework are considered to be arm’s length under section 482 of the Internal Revenue Code, providing certainty for taxpayers regarding double taxation, foreign tax credits and permanent establishments in relation to transactions with their maquiladoras.

The 2020 renewal agreement maintains the core elements of the 2016 QMA's TP framework and explicitly confirms that it is considered to continue to produce arm's length results. However, the renewal agreement also has several important additional features.

2020 QMA renewal

In November 2020, the IRS announced an additional renewal of the QMA particularly relating to TP methodology for maquiladoras. An election similar to the one for the previous amendment will be possible for taxpayers already in the process of negotiating and obtaining an APA for their maquila activity following the 2016 Agreement. Even though the new agreement supports the terms of the previous agreements, it addresses additional issues that have been identified by both countries as creating the risk of double taxation.

One issue that is clear from the IRS communication relates to the application of a new economic adjustment for intercompany receivables. Although neither the terms of the agreement nor the specific issues around intercompany receivables that were analyzed by both authorities are known in detail as of today, there are situations in which a maquiladora has an outstanding accounts receivable balance that the competent authorities agree is inconsistent with the TP profile of the maquiladora. Thus, a mechanism for addressing such situations was included.

A typical reason for intercompany receivables held by a maquiladora could for example be a sale of the machinery and equipment to the principal due to a change in the domestic law mandating that maquiladoras can no longer own these assets to qualify for the regime. To address this change, such assets were typically sold to the principal in exchange for a note, and resulting receivables are to a large extent still outstanding. This has created a controversy between the IRS and SAT.

The impact of Whirlpool Financial Corporation v. Commissioner [154 TC. No. 9, May 5, 2020] on the new agreement is yet to be determined in detail. In the underlying case, the taxpayer relied on a structure in which a Luxembourg affiliate acted formally as the contract manufacturer but assigned the actual toll manufacturing responsibilities to its maquiladora. The IRS successfully argued that the structure results in subpart F income taxable in the US.  However, this case is still ongoing, so its ultimate impact remains uncertain.

Relevance of the latest QMA renewal

The 2020 agreement will be applicable for tax years until 2019. In the agreement, the competent authorities also commit to an analysis for the tax year 2020 and subsequent years and to further negotiation between the two authorities. The communication is clear in saying that the future renewal will include a methodology that contemplates the impact of current economic, commercial and public health conditions in accordance with the OECD’s Working Party 6 and the Forum on Tax Administration Mutual Agreement Procedure Forum.

Taxpayers may inquire with the IRS Advance Pricing and Mutual Agreement (APMA) program regarding whether the QMA is appropriate for their facts and circumstances or whether a bilateral APA between the United States and Mexico may be more suitable.

The Mexican tax authorities have not yet formally communicated this agreement, nor have they published the rules of application. However, SAT will directly notify eligible Mexican taxpayers. Notifications will include details on the steps taxpayers must take with their pending unilateral APA requests.

Given the impact and the potential benefits of this agreement for manufacturing activities in Mexico, it is vital for taxpayers in the US and Mexico to carefully monitor future developments about the QMA and Its possible benefits to their business.

Please contact the author or your usual DLA Piper advisors to learn more about the impact of QMA on your transfer pricing arrangements.