The new challenges in outsourcing services for the automotive supply chain in Mexico

Mexico is one of the world's most competitive countries in the automotive sector, as it is home to the main manufacturers of vehicles and has an extensive network of domestic and foreign companies that supply chain of automotive components and specialized services in the sector.

The complexity of automotive projects requires the need to use third-party companies for the manufacturing and development of a variety of auto parts, which include cast and die-cut parts, plastics, aluminum and more specialized components for the engine, steering, suspension, among others.

Consequently, outsourcing or subcontracting has become a commonly used scheme for companies that participate in the automotive supply chain with a high level of specialization for the volume manufacturing and development of auto parts.

Furthermore, within this complex automotive supply chain there are also basic specialized services such as transportation and logistics, to more complex services such as CAD/CAM, automation, engineering, machining and manufacturing, among others. Even there are some highly complex projects that demand components of supply chain of automotive parts and the provision of specialized services as a whole.

In light of this situation, we have identified new challenges within the automotive supply chain, particularly in those projects that involve a component consisting of the provision of services, because the recent subcontracting reform regulates for first time the provision of "specialized services" by third companies (subcontracting of services).

The above mentioned is particularly applicable to Tier 1, 2 and 3 companies, which have executed agreements that involve the assignment of their employees to the establishments or workplaces of their contractors (Mexican OEMs and Tier 1 and 2), which technically implies "making such employees available" to the contractor and, consequently, such specialized services are subject to the scope of the Reform, which imposes new obligations on the contracting and subcontracting companies. This can be visualized in the following diagram:

In order to provide a comprehensive overview, it is important to make a brief reference to such reform. On April 23, 2021, a subcontracting reform was published in the Official Gazette of the Federation in Mexico, through which the subcontracting of workers is prohibited and the subcontracting of services and specialized construction is now regulated. The reform has three important components: labor, social security and tax.

Labor component

The Federal Labor Law ("LFT") sets forth that Mexican companies may keep subcontracting services or construction works, as long as they have a ""specialized"" nature. To this effect, the LFT sets forth that a service will be specialized when: (i) the subcontracted activity does not be part of the business activity of the company that hires them; (ii) it does not comprise the principal economic activities of the contractor and; (iii) the subcontractor party has its registration as a specialized service provider before the labor authority.

Therefore, business models that use outsourcing or subcontracting schemes as a part of their operations, like the automotive sector, have had to make certain amendments at the corporate, contractual and tax aspects in order to avoid potential labor and tax risks, but most importantly, to continue with the operation of subcontracting to third companies for the provision of specialized services.

On this particular case, we have identified that some companies (Tier 1, 2 and 3) affiliated to different Automotive Clusters have a wide "corporate purpose" that includes the performance of all kinds of activities related to the manufacturing and provision of services related to automotive components and, therefore, in compliance with the Reform, they could not be allowed to continue subcontracting services to third party companies because they do not fulfill the requirement of "specialization" of such services. In some particular cases, we have even identified that the subcontracted services may be considered part of the main economic activity of the contracting or beneficiary company.

The above scenario represents a new challenge in the outsourcing of services in the automotive supply chain, since companies in the sector are now having to make adjustments at the corporate structure Mexico level, amending their business activities in order to limit the scope of their business activities and eliminate any other secondary activities that need to be outsourced and justify their specialization; Also, these companies have had to amend agreements with their clients and suppliers to define and limit the scope of the subcontracted services; and finally involves modifications to their economic activities declared before the Mexican tax authorities in order to be consistent and have cohesion in their business model.

Tax component

The Reform also has a relevant tax component for contractors (national OEMs and initial Tier 1s) and subcontractors (Tier 1, 2, 3 and 4) since they will have to implement corporate measures to mitigate potential tax risks in their commercial relationship.

In order to provide more complete explanation of the potential risks, it is necessary to make a brief reference to the tax implications that could be triggered for contractors and subcontractors that participate on specialized services relationship in line with the Reform.

The Reform also amends the Mexican Federal Tax Code ("CFF") to establish that payments made for specialized services will only be deductible for corporate income tax purposes (“CIT”) and creditable for value added tax purposes (“VAT”), as long as the subcontractor has a Registry of Specialized Services before the Ministry of Labor and Social Welfare ("Secretaría del Trabajo y Previsión Social" or "STPS") and also complies with several formal obligations set forth in the Income Tax Law ("Ley del Impuesto sobre la Renta" or "LISR") and the Value Added Tax Law ("Ley del Impuesto al Valor Agregado" or "LIVA").

The LISR and the LIVA set forth as new formal obligations for the subcontractor to provide the following documentation to the contracting party: copy of the tax receipts for the payment of workers' salaries; copy of the payment receipts issued by the bank; copy of the payment of employer contributions to the Mexican Social Security Authority; payment of contributions to Mexican Housing Authority; VAT returns and the acknowledgement of receipt of payment, among others. This documentation must be provided monthly by the services provider.

In this context, some contractors will have to request from their specialized service providers -Tier 1, 2 and 3 - the registration before the STPS as specialized service providers, as well as the formal documentation that supports the monthly compliance of their income tax and VAT obligations.

In the event of non-compliance with such requirements, the contractors (national OEMs and initial Tiers) shall not deduct the payments made to their services providers for corporate income tax purposes, and the VAT transferred will not be creditable either. For this reason, this reform is important at an operational level, since it becomes a "compliance chain" that could have implications at a commercial level, since no company will want to do business with a service provider with whom it cannot deduct its payments or credit the VAT transferred.

Additionally, in the case of companies that determine monthly VAT refunds, they must also fully comply with the new credit requirements introduced with the Reform, otherwise, the tax authorities could reject the refund of the requested tax amounts and cause problems of lack of cash flow for the companies.

In accordance with this Reform, companies are taking measures in two aspects: on the one hand, the service providers are analyzing whether they are obliged to register as specialized service providers before the STPS and, jointly with the contractors or beneficiaries of these services, they are making certain adjustments in their articles of incorporation to limit their business purposes, also amendments to their services agreements and filing notices to modify their tax situation before the Mexican Tax Authority in order to continue subcontracting the specialized services.

Based on the foregoing, we consider that the current situation of the contracting companies (Tier 1) and subcontractors (Tier 2, 3 and 4) in most of the projects will maintain and will necessarily lead to the implementation of legal adjustments to mitigate labor and tax risks and, in this sense, the contracts previously executed will maintain in force. In fact, we expect that those agreements would be difficult to cancel, since it would be costly to interrupt production processes that had a kick-off several years ago.

However, we are of the opinion that for future projects, compliance and control of labor and tax risks will be an additional component that OEMs will consider before executing an agreement for the supply and provision of services for automotive components with Tier companies, therefore a new element must be taken into account in this complex automotive supply network of high demand, exigency and competitiveness. The above comments are illustrated in the following diagram:

It is important to mention that the labor component of the Reform became effective last April 24, so the SPTS has already issued the guidelines that must be fulfilled in order to submit the application to obtain the Registration and also the electronic platform is already available which is the means to make the process.

The tax component will become effective as of August 1st of this year.

This document, except for errors or involuntary omissions, is our opinion on the issues raised by our clients and based on our experience in the automotive sector and is not intended to solve general doubts or consultation of the industry or sector, so it is recommended to analyze and evaluate each individual situation.

For further information on the potential labor, social security and tax implications of each individual situation, please contact our specialists through the following email: contact@globaltaxsolutions.com.mx or directly through our telephone lines and social networks.