Mexican tax authorities examining maquiladora transfer-pricing practices.

Recently, the Mexican tax authorities publicly announced their intention to focus on transfer-pricing policies with regard to transactions between maquiladoras and their foreign parents. They have made general statements that more of the total worldwide profits from the sale of products produced in the maquiladoras should be subject to Mexican income tax.

The Mexican tax law currently requires that transfer-pricing arrangements between Mexican subsidiaries and their foreign parent companies reflect those which would occur between inde pendent parties in an arm's length transaction. In addition, Article 5(5) of the U.S./Mexico Income Tax Treaty provides that a U.S. company may be deemed to have a permanent establishment in Mexico; as such, the U.S. company may be subject to Mexican income tax on the profits from the sale of products processed in Mexico by its maquiladora. However, under both the treaty and a recent revision to the Mexican tax law, a permanent establishment can be avoided if the U.S. company can demonstrate that its transactions are carried out with the maquiladora at arm's length. While it has yet to be determined, recent statements by the Mexican tax authorities suggest they will focus on transfer pricing (possibly working together with the U.S. tax authorities), rather than the more difficult administrative effort of assessing and collecting tax from the U.S. parent related to a permanent establishment in Mexico.

Any change in maquiladora transfer pricing could have significant consequences to the approximately 1,600 companies with over 2,000 facilities currently participating in the maquiladora program. Maquiladoras typically have a 1%-5% cost plus arrangement with their foreign parent that may not represent arm's length transfer pricing. In light of this, many maquiladoras could expect an increase in their Mexican taxable income. If the susidiaries are U.S.-owned, these increases could result in such unfavorable outcomes as:

* Increased overall U.S./Mexico tax liability, due to foreign tax credit limitations.

* Increased U.S. penalty exposure, if the Mexican tax authority's profit valuation exceeds levels acceptable to the IRS under Sec. 482.

* Increased income subject to the 10% Mexican mandatory profit-sharing contribution (some or all of which could be nondeductible in Mexico).

* Increased U.S. customs duties on reimportation of assembled products to the United States.

A maquiladora trade organization has initiated its own study intended to generate a coordinated response to the statements of the Mexican tax authorities. Although a maquiladora-wide formula for transfer pricing may be possible, more likely this approach would be fundamentally inconsistent with the facts and circumstances approach favored by the Service. Therefore, since the maquiladoras have significant differences in functions and risks, each U.S. maquiladora owner should undertake its own analysis to determine which functions and risks are undertaken (and, therefore, where profits should be allocated).