Mexico Walking Fine Line to Tax Maquiladoras

Lured by minuscule taxes, cheap labor and proximity to the U.S. market, corporate America has flocked to Mexico in the last two decades, opening thousands of maquiladora factories in a country hungry for jobs and investment dollars.

Now Mexico, brimming with confidence but hard up for money, wants to collect new taxes from the export-driven factories. And that has opened a taxing can of worms.

Barring a change in the U.S.-Mexico income tax treaty, a Mexican law due to take effect in January would suddenly subject the U.S. firms to double taxation--unless Uncle Sam is willing to give up its right to tax the firms’ Mexican operations.

Predictably, the maquiladoras are howling. Some are threatening to move their factories to China or, more credibly, to Honduras, El Salvador and other Central American countries that have established equivalents to the maquiladora system.

Then again, abandoning a cheap-labor nation that shares a free-trade border with the world’s largest market seems an unlikely course of action.

Indeed, the dispute brings into focus a maturing Mexico, one that has much to offer foreign businesses and no longer feels it has to give away the store to attract them.

“Mexico has tremendous leverage now with these companies,” said Allen Delattre, a consultant for Anderson Consulting in Los Angeles. “It has gone from being a low-cost, convenient labor provider to being a viable competitor in its own right. The businesses there now have momentum bigger than the maquiladora program, bigger than NAFTA and bigger than international taxation issues.”

Nor is there any doubt about the justification for greater tax revenue: It’s needed to tend to the squalor that has accompanied the explosive growth of the maquiladoras themselves.

Still, resolving the tax dispute sensibly will be a measure of Mexico’s maturity as a trading nation. A heavy tax burden, or a prolonged period of uncertainty, could cool the ardor of prospective maquiladoras. They could look to Honduras, where dozens of maquiladoras already employ more than 100,000 and enjoy comparable tax and duty advantages with the United States.

“Mexico has a fine line to walk,” Delattre said. “If the [tax] changes become disadvantageous, that creates opportunities for other Latin American countries that also are trying to industrialize. Certainly, no plants will close in Mexico, but they may not open at the rate or scale that Mexico wants.”

New Law Would Close Old Loopholes

The tax confrontation was triggered by Mexico’s passage last December of a law that would reclassify most of the 4,500 maquiladoras from temporary to permanent business establishments as of this Jan. 1, eliminating tax loopholes they have enjoyed since the mid-1960s.

Under the current tax treaty, tax experts say, the result would be to suddenly subject U.S. manufacturers to corporate income taxes in both countries.

A flurry of talks is occurring this month in Washington, where Mexican tax officials are asking the U.S. to forgo tax revenues it now collects on the maquiladoras. But negotiators have been unable to reach agreement, and Mexican officials have indicated they will postpone the effective date of the new tax until the dispute is resolved.

The IRS refused to comment on the talks.

The industry, however, wants immediate clarity rather than a postponement so its members can plan long-term investment strategies. Kimberly Pinter, a tax attorney at the National Assn. of Manufacturers in Washington, said that in extreme cases companies could be subject to combined taxes of up to 75% under the new law.

“This would kill the maquila industry in Mexico,” Pinter said.

John McLees, a Chicago-based Baker & McKenzie tax attorney and advisor to the National Maquiladora Trade Assn., said that even if double taxation is somehow eliminated, reclassifying maquiladoras from “processing centers” to “permanent establishments” would open the door to taxing a company’s worldwide profits in the future.

But Mexican authorities from President Ernesto Zedillo on down have repeatedly sought to assure the maquiladoras that the government will do nothing to harm an industry that now employs 1.1 million people and whose work force is growing by 10% a year.

“We do want to charge more taxes. Certainly we feel we can and should charge more taxes on such a significant sector,” Mexican Trade Secretary Herminio Blanco Mendoza said. “What we don’t want is to have any of these firms close down. It is a very delicate balance.”

Maquiladoras date from 1965, when the two countries created their special tax and duty status as a way to replace the jobs lost with the phasing out of the bracero program that had allowed Mexicans to work temporarily in the United States.

Maquiladoras boomed after the Mexican currency devaluations of the 1980s and 1990s. A weak peso made Mexican labor cheap enough that it could compete with other manufacturing countries, especially in Asia, that until then were reeling in most of the offshore plants.

The maquiladoras themselves have grown steadily more sophisticated, evolving from simple “assemblers”--the direct translation of maquiladoras--to become in some cases sophisticated high-end producers of computers and other electronic goods.

In addition to cheap labor, the attraction for U.S. owners is that as long as the products are sold in the United States, the owners don’t pay duty on the components, raw materials and machinery they bring into Mexico.

The North American Free Trade Agreement in 1994 greatly fueled the maquiladora boom by making Mexico the premier platform for exporting into the United States. Asian and European companies climbed on board, incorporating as U.S. firms and getting maquiladora tax advantages.

The importance of maquiladoras, to both Mexico and their foreign owners, is clear: Their exports have doubled in five years to $52.8 billion in 1998, accounting for 46% of Mexico’s total exports. The number of maquiladoras is expected to grow by 15% or more this year alone, approaching 5,000 plants.

Employment could exceed 1.2 million at year’s end, more than double 1994 figures. Salaries, while woefully below U.S. levels, remain about 30% higher than in other Mexican industry.

But the boom in maquiladoras has had two downsides for Mexico:

First, the government has struggled to find tax money to pay for schools, electricity, sewage systems, roads and other infrastructure to cope with the huge maquiladora-driven growth that is overwhelming communities, especially along the U.S.-Mexico border.

Second, the maquiladoras have remained largely separate from the rest of Mexico, creating a kind of two-tier economy favoring the northern part of the country. Hardly any of components assembled in maquiladoras are made by Mexicans; nearly all come from U.S. factories.

Maquiladoras ‘Are Like an Island’

“If we look at maquilas as a model for economic development, we would be making a mistake,” said Pedro Gonzalez, an economist at the Mexican Institute for Political Studies. “The inputs made in Mexico and used by maquiladoras are as low as 2% and rarely reach 10%.

“This implies that the great expansion and dynamism of maquiladoras doesn’t have the desired multiplier effects for the rest of the economy. They are like an island.”

But such issues are of secondary importance for U.S. companies, such as Plantronics, that have located in Tijuana, one of Mexico’s biggest maquiladora centers. Remaining competitive in the global marketplace is what they’re after, and they contend the tax would make Mexico less attractive by raising costs.

“This tax will discourage investment here,” said Cesar Lopez, manager at a Plantronics telephone headsets assembly factory in Tijuana. “At the same time, China is making it very attractive for companies like ours. You pay workers only $2 per day, there are no unions, no turnover, and the central government takes care of everything.”

The new law would subject the maquiladoras to normal Mexican income tax, based on the profit generated within the Mexican operation. That is standard practice worldwide. The difference here is that most of the biggest maquiladoras are U.S. companies, and U.S. tax law assesses corporate tax based on global operations. Therefore, unless the firms can get a credit on their U.S. taxes for income taxes they have paid in Mexico, the companies would be taxed twice.

Luis de la Calle, deputy trade secretary in charge of international negotiations, said Mexico is asking the U.S. Treasury to forgo the tax revenues from maquiladoras that are generated by their Mexican operations.

Mexico has gradually increased its tax bite on maquiladoras, from negligible to merely minimal. But the current rate is still a highly favorable arrangement for the foreign manufacturers, and the system is virtually free of red tape.

Mexico would prefer the maquiladoras to shed their special status and become like all other multinational firms, said Raul Hinojosa Ojeda, a UCLA professor who follows the U.S.-Mexico economy. For more than a decade, Mexico has tried to do away with special treatments it once gave to a number of industries, and it sees lightly taxed maquiladoras as having a “distortionate” effect on other Mexican manufacturers.

The looming tax change certainly hasn’t slowed the influx of maquiladoras this year. But U.S. lobbyists say those plans were set in motion years earlier and that the flow will slow, if not stop, once the tax takes effect.

“Investment is still high because a big majority of the new investors are just not aware of some of these potentially onerous tax proposals,” said Tony Ramirez of Made in Mexico, a San Diego-based maquiladora consulting firm. “They know what’s on the books now but aren’t so clear on how they may be affected in the future.”

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Kraul reported from Tijuana and Smith from Mexico City.

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Maquiladoras on the Rise

The number of maquiladoras factories in Mexico has soared in the 1990s, and 1 million people now work in them. Mexico is seeking more tax revenue. Number of maquiladoras:

1999 (projected): 4,500

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Source: Mexico secretary of trade and industry.