BONUS CONTENT: Maquiladora

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Maquiladora is such a lovely word, it’s almost a shame that it’s used for a tax concept.

Well, tax and trade. The maquiladora regime has existed along the Mexican side of the U.S./Mexico border for decades, as a way to attract foreign-based multinational investment and boost manufacturing jobs.

Also known as the maquila, it’s derived from the Old Spanish term for the “miller’s share”--an amount of grain that a hired operator of a mill can keep for himself. With a maquiladora, a foreign manufacturer can import raw materials into Mexico, manufacture them into finished goods with Mexican labor, and then ship those products to be sold elsewhere–with a reduction in custom duties and, at least for a time, reduced corporate taxation. The manufacturing facilities themselves will also be owned by non-Mexican entity. Just about everything in the operation is foreign to Mexico, at least on paper–except for the workers. (In theory, the products could still be sold in Mexico, but they must use a separate entity from the maquila for distribution.)

Beginning in the 1960s, the maquiladora industries have steadily grown, exploding as Mexico-U.S. commerce surged post-NAFTA.

It also became somewhat of a model for “free trade zones” elsewhere–places where national distinctions are watered down or disregarded outright, in the name of boosting trade and generating employment. In fact, because so many of these operations are near the U.S.-Mexico border, the maquiladora have become a significant boost to employment on the U.S. side as well.

It grew into somewhat of a Frankenstein’s monster for the Mexican government, becoming so large and fast that the legislature has sought to reduce the tax benefits somewhat. Those changes, along with new Trump-era tariff policies in the U.S., have created new international tax complications for the maquiladora. Many companies have left the program entirely.

Part of the benefit of operating a maquiladora is to smooth out international tax issues that would otherwise emerge from a Mexican manufacturing operation. Under the program, the corporate group can use Mexican workers without fearing that it could be considered a permanent establishment. The Mexican government also offers a safe harbor for companies to determine profit margins for transfer pricing when using a maquila.

Aside from the safe harbor, companies could apply for a unilateral advance pricing agreement from the Mexican tax authority, that would set prices for five years and protect companies from audits. Beginning in 1999, the U.S. Internal Revenue Code has made agreements with Mexico to respect those unilateral APAs. It’s not quite the same as a bilateral APA, but it’s an assurance that using the maquiladora will make tax compliance easier in the U.S., as well.

A U.S.-Mexico agreement is still in place for 2024–but in 2022, the Mexican legislature removed the APA option for 2025 and beyond, leaving the safe harbor as the primary method. The safe harbor requires a markup of 6.5% profit on operating costs and expenses, or a 6.9% return on assets owned by the maquiladora and assets and inventory of the foreign entity. Since this is generally less favorable to taxpayers than the APA terms, this change prompted many manufacturers to reconsider whether a maquiladora is still cost-effective.

The trade benefits for using the maquiladora may also be lessening as well. Chris Demond, a trade expert at PwC, noted in a recent Crossborder Tax Talks podcast that Mexico has been instituting new tariff policies that don’t include a maquiladora exemption. As the U.S. has increased tariffs on China and other disfavored nations, Mexico has emerged as a potential destination to reroute those products and reach U.S. manufacturers. That has prompted the U.S. to push for Mexico to increase its own protections, and that has left the maquiladora exemptions in the dust.

And then there’s Pillar Two. As regular readers no doubt are aware, the Organization for Economic Cooperation and Development’s global minimum tax can take a harsh view of local economic incentives like the maquiladora. Many companies using maquilas may be affected, if the tax benefits reduce their overall tax rate significantly. Given that these companies tend to be in manufacturing-heavy industries, it’s not totally clear how much it would hurt–but just modeling the potential tax risks could be the true cost. Unlike many other government-provided tax incentives, there also isn’t an easy way to convert the maquiladora into a Pillar Two-friendly regime.

Given Donald Trump’s 2024 re-election victory, the future of these kinds of U.S.-Mexico free trade benefits is cloudy. One of the major accomplishments of his first term was to renegotiate NAFTA, ultimately replacing it with the United States-Mexico-Canada Agreement (USMCA), which heightened auto production restrictions which generally disfavor Mexican labor. It’s a decent bet that there will be increased focus on whether the maquiladoras are being used as a way to sneak material from China or other countries with higher tariffs–aside from additional tariffs, this could add further compliance costs to what’s supposed to be a smooth transaction.

There’s also the issue of the auto industry’s evolution. As cars have become more high-tech and complicated, the sector has slowly moved away from low-wage, low-skilled labor in the search for workers with more training. The shift to electric vehicles, boosted by the 2022 Inflation Reduction Act’s generous credits, has only accelerated that trend. It’s not that Mexico’s labor force isn’t capable of adapting–but as they do, the wage benefits of maquiladora are lessening. Along with these other factors, the costs could become prohibitive. (See more in this report from the Dallas Federal Reserve.)

Despite all this, the maquiladora clearly aren’t going away, and the U.S. Treasury Department and IRS will no doubt continue to look for ways to make tax compliance for those structures easier. In a sense, it’s a demonstration of a dynamic with increasing frequency–the push from tax administrations to simplify and ease compliance is running into the political headwinds of more and more protectionist barriers between nations.

Contact the author at amparkerdc@gmail.com.