MEXICO BUSINESS FRAMEWORK

David D. Spencer and Fernando Rivadeneyra
©Rivadeneyra,Treviño y De Campo, David D. Spencer

1. SCOPE

The purpose of this document is to describe the framework for conducting business in Mexico as well as to provide insight regarding the business environment and the financial, tax and legal implications of running, or working for, a Mexican business entity, either in the form of a corporation, a subsidiary of a corporation, or a branch. This document also provides a brief description of certain legal and tax incentives for Mexican-based or targeted business.

2. CHOICE OF ENTITY: FORMS FOR A BUSINESS IN MEXICO

Businesses in Mexico can be established either as companies or branches of foreign corporations and partnerships.

The corporation must be registered in the different offices of the government, such as the Ministry of Finance and Public Credit, The Ministry of Economy (Secretaría de Economía, formerly the Ministry Commerce and Industrial Development, or SECOFI), Registry of Commerce, with the federal and local tax authorities, as well as other agencies depending upon the activities of the corporation.

The main forms of incorporation of Mexican business entities are the following:

Corporation (Sociedad Anónima or SA).

The great majority of businesses in Mexico are in the form of an SA. This is what is known in common-law jurisdictions as a stock corporation. The SA has separate juridical personality. It must have at least the statutory minimum capital divided into transferable shares. Shareholders have limited liability. There must be a minimum of two shareholders (individuals or business entities with juridical personality). The capital contributions or ownership interests of shareholders are evidenced by shares, with the minimum capital required being MP$50,000 (fifty thousand Mexican pesos). At least twenty percent (20%) of the capital must be paid in upon issuance and may be supplied in goods or cash.

Limited Liability Company (Sociedad de Responsabilidad Limitada or S de RL).

A limited liability company also has separate juridical personality. This entity must have a minimum of two (2) shareholders and a maximum of fifty (50). A minimum of MP$3,000 is necessary to incorporate an S de RL and at least fifty percent (50%) of the share capital must be paid in upon issuance. The shares can only be transferred by prior approval of the majority of the shareholders.

General Partnership (Sociedad en Nombre Colectivo).

No minimum capital is required, but the consent of all partners is necessary for modification of partnership interests. The partners are jointly and severally liable for the partnership's debts. Profits and losses are divided in proportion to each partner's contribution.

Limited Partnership (Sociedad en Comandita Simple).

This is a commercial company with at least one general partner and one or more limited partners. The liability of the general partner is unlimited with respect to the obligations of the entity, while that of the limited partners is limited to their capital contribution. Limited partners cannot participate in the management of the company.

Partnership Limited by Shares (Sociedad en Comandita por Acciones).

Similar to the previous category, this type of company is unique in that the shares of stock they own limit the members’ contributions.

Joint Venture (Asociación en Participación or A en P).

An "A en P" is not ordinarily disclosed to third parties. It is formed by a written agreement that requires neither registration nor public notice. The active associate (asociante) is personally liable for the debts of the joint venture, whereas the contributing associate (asociado) is liable only to the extent of his contributions. Although a contract is normally written, it need not be recorded at the Public Registry of Commerce. A joint venture cannot do business under a company name but must use the name of the active associate.

Civil Company and Civil Associations (Sociedad Civil y Asociación Civil).

Civil companies and associations are non-profit organizations formed by several individuals with the purpose of achieving a common goal. The most common partnerships of this type are charities, professional associations and scientific, cultural and religious institutions.

Branches of Foreign Entities (Sucursal).

A foreign investor may open a branch operation rather than set up a separate Mexican subsidiary. However, a more practical approach is to establish a Mexican corporation with foreign capital. A branch must be registered with the Public Registry of Commerce after obtaining authorization from the Foreign Investment Commission (FIC) and other government agencies. Representative (non-trading) offices may be set up simply by notifying the FIC.

Sole Proprietorships.

The Commercial Code of Mexico allows individuals to engage in all kinds of trade. Resident foreigners with work permits can also deal in commercial activities. The difference between an individual enterprise or sole proprietorship and a corporation is that the stockholders in the latter have limited liability, whereas in the former an individual's liability is unlimited.

3. FOREIGN INVESTMENT LEGISLATION

Foreign investment in Mexico is governed by the Foreign Investment Law (FIL), its Complementary Regulations (CR) and Special Resolutions (Resolutions).

Although most economic activities are open to foreign investment, some are classified by the FIL as "Restricted", "Reserved" and "Regulated". A description of these classifications follows.

Note: Some activities in the following categories have been opened to specific projects by foreign investors through private letter ruling, issued by the appropriate authority.

Restricted Activities. Certain activities are reserved to the Mexican Government. Since they are regarded as strategic, foreigners are not allowed to directly or indirectly participate in them. These activities include:

* Petroleum and Hydrocarbons

* Electricity

* Atomic energy generation

* Radioactive minerals

* Satellite communications

* Telegraph

* Radiotelegraphy

* Bill issuance

* Coin minting

* Mail

* Others contained in specific laws

The Mexican Constitution grants Congress the authority to determine which economical activities are classified as "strategic" according to the economic, social and political environment. Therefore, the "restricted" activities may vary unexpectedly. For instance, with the purpose of recuperating some of its lost economic strength, the Mexican Government has initiated certain legal procedures whereby formerly heavily-restricted activities, such as certain petrochemical and airport and railroad operations, will progressively be opened to foreign Investors, although to a limited extent.

Reserved Activities. These are activities open only to Mexican nationals, or Mexican corporations with charters that exclude foreign shareholders (the so-called "Exclusion Clause for Foreigners”). However, the FIL states that foreign investment is allowed in these activities. Following is a list of the principal reserved activities:

* Passenger, tourist and cargo transportation throughout the Mexican territory, excluding delivery packages and documents.

* Radio and television broadcasting services, excluding cable television.

* Professional and technical services, in accordance with the corresponding laws.

Regulated Activities. Those activities in which direct foreign investment is allowed in certain percentage limitations. The principal examples:

1. Up to 10%:

* Cooperative societies of production

2. Up to 25%:

* Domestic air transportation

* Airtaxi transportation

* Specialized air transportation

3. Up to 49%:

* Holding companies of financial groups

* Multiple banking institutions

* Stock brokerage houses * Stock market specialists

* Insurance corporations

* Bonding institutions

* Money exchange houses

* Newspaper Printing and publishing for exclusive circulation in the National Territory

The allowable foreign investment in certain reserved, heavy industry activities, such as assembly of auto parts and construction will be increased over time.

The FIL's Complementary Regulations created the National Foreign Investment Commission, which is in charge of granting all special authorizations and private letter ruling regarding foreign investment in Mexico.

The other foreign investment governing body is the Foreign Investment Registry, which records and controls all foreign investment operations.

All foreign investment corporations must file a yearly financial and economic report with the Registry. The report must be filed by April 30 of the following year. Also, foreign investment corporations must notify the Registry of any modifications to their capital structure no later than forty (40) days after the modifications are made.

4. ENVIRONMENTAL AND INTELLECTUAL PROPERTY LEGISLATION

Environment

The General Law of Ecological Equilibrium and the Protection of the Environment (the “Environmental Law”) is the main Mexican environmental statute. It contains specific chapters concerning air, water, soil, hazardous waste and material, noise, vibration, thermal energy, lighting, odor and visual pollution. It also sets out enforcement procedures and other provisions concerning the respective responsibilities of the federal and state governments.

The Ministry of Environment (SEMARNAP) is the federal body that oversees the enforcement of environmental law.

A program has been established whereby environmentally-hazardous companies are encouraged to carry out environmental audits in their facilities, with the purpose of allowing the companies to correct any deficiencies detected.

Intellectual Property

Intellectual property is governed in Mexico by the “Law for the Encouragement and Protection of Industrial Property", which substantially improves previous Mexican legislation regarding these matters.

This updated legislation is in line with the overall economic and legal changes that have been occurring in Mexico since the mid-80's, with the purpose of creating a more competitive market environment. The main purpose of this legislation is to offer a legal regime in Mexico for the protection of intellectual property in terms comparable to those existing in industrialized countries. Thus, individuals and corporations in Mexico (national or foreign) may have similar protection as that available to their competitors in other countries.

This legislation facilitates the transfer of technology and stimulates local research and development efforts, with the aim of improving productivity and quality in all industries.

In addition, this legislation follows the mainstream of international law on protection of intellectual property, as reflected in the principal international treaties in this area. It was influenced by the work done by the World Intellectual Property Organization (WIPO), GATT, and NAFTA.

5. TAXATION OF MEXICAN CORPORATIONS

All business entities (whether corporations or partnerships, domestic or foreign owned) are governed by the same tax regulations. The following is a brief description:

Income Tax (Impuesto Sobre la Renta)

Income tax is calculated at a thirty-five percent (35%) flat rate applied to the net taxable income, which is computed by subtracting the allowable deductions and carry forward losses from the net revenues.

No income tax is charged or withheld to/from the stockholders when they receive dividends paid from Mexican corporations; rather, the distributing corporation is liable for paying the tax at a 35% rate. However, if the dividends are sourced from the company's "Net Taxable Profit Account" (NTPA), no income tax is assessed to either the recipient or the company. The NTPA must be computed by using specific mechanics, as provided in the Income Tax Law.

Tax payments must be filed in advance periodically during the year. These payments are credited against the year-end income tax return, which is due March 31 of the following year.

Corporations are not obligated to file tax payments in advance during their first year of operations. This, however, does not relieve them from filing a year-end tax return for that same year.

Net after-tax losses can be carried forward to the following ten (10) consecutive years. There is no carry back of such losses.

Certain activities, such as land transportation, agriculture, fishing, publishing of cultural or educational material, small-scale commerce, receive protection under Mexican tax law and therefore may be eligible for preferential tax regimes.

Asset Tax (Impuesto al Activo)

Asset tax is a minimum tax computed on the taxable asset base, as determined by using special mechanics provided in the Asset Tax Law. The applicable tax rate is 1.8%. This tax is complementary to the Income Tax, and therefore only the higher of the two taxes is paid.

As of January 1, 1995, corporations are exempt from this tax for the pre-operations period and the first two years of operation. Consequently, corporations are obligated to pay this tax beginning with the fourth year of operation.

Value Added Tax (Impuesto al Valor Agregado)

The following activities are subject to VAT when performed within Mexican territory:

* Alienation of goods

* Rendering of independent services

* Leasing or rent of goods

* Importation of goods and services

On the one hand, the taxpayer charges VAT to its customers or clients, and on the other it pays VAT charged by its suppliers. The basic calculations is as follows

VAT collected on applicable activities
(minus)
VAT paid on deductible expenditures
(equals)________________
Net VAT balance

If the net VAT balance is higher than 0, it is shown on the advance payment tax return and paid to the tax authorities as "VAT Payable". If the net VAT balance is less than 0, compensation against future "VAT Payable" or a request for refund is possible. This difference is known as "VAT Recoverable".

The general VAT rate is 15% in most parts of the Mexican territory. A 10% VAT rate prevails in specific border zone areas.

Tax on Salaries and Payroll-related Obligations

Mexican employers are obligated to pay the following taxes and contributions:

* Local tax on total payroll payments (fluctuating from 0.00% to 2.00%)

* 5% National Worker's Fund (INFONAVIT)

* 17.42% approximately, for Social Security (IMSS)

* 2% Savings Retirement Fund (SAR)

In addition, the following taxes are withheld from employees:

* Income tax, computed using progressive income bracket tables. Tax rates range from 0% to 35%

* 4.375 % for Social Security

Employee's Profit Sharing (PTU)

The employees of Mexican corporations are entitled to receive 10% of the corporation's net profit, as shown on its year-end income tax return. This additional tax burden, along with income tax, brings year-end obligations to 44% of the net profit. No carry forward of losses is allowed for PTU computation and distribution purposes.

Newly established corporations are not obligated to PTU distribution for the first year of operation. Also, newly established corporations engaged in the manufacturing of new products are PTU exempt for the first two years of operation.

Treaties to avoid Double Taxation

During the 1990's, Mexico entered into treaties to avoid double taxation with its main commercial partners.

With the entrance of the country into the Organization for Economic Cooperation and Development (OECD) in March 1994, treaty negotiations with other country members speeded up.

The main purpose of tax treaties is to reduce and in some cases eliminate double taxation, so as to avoid a foreign resident from paying income tax in both Mexico and in its country of residence.

Very attractive tax reductions and exemptions are contemplated in most of the treaties already in force; good examples of these are:

Type of Income Tax Rate Tax Rate without Treaty with Treaty

Interest Maximum 35% Maximum 15% (4.9% in some cases)

Construction, Maximum 30% No withholding installation, tax in Mexico maintenance & assembly services

Technical Assitance Maximum 35% No withholding tax in Mexico

Although provisions may vary from treaty to treaty, the above tax rates are found in most.

Another important incentive included in the treaties is the credit of the tax paid in Mexico against the resulting tax in the country of residence (foreign tax credit). Although this is already figured in the Income Tax Law (to a limited extent) the treaties include simpler mechanics for tax credit.

Transfer Pricing

The Mexican tax reforms in force as of January 1, 1997 dictate the special rules whereby Mexican taxpayers that carryout any type of transactions with related parties must determine their intercompany prices. In general terms, such rules comprise the following:

Mexican taxpayers are obligated to keep contemporaneous documentation, as part of their accounting records, which supports that intercompany prices are in compliance with the “arm’s length” principle (i.e. prices at a level reasonably equivalent to the amount that the Mexican Company would charge an unrelated third party in similar or comparable uncontrolled transactions).

In order for Mexican taxpayers to comply with the arm’s length principle, the Mexican Income Tax Law sets forth the transfer pricing methods that may be applied. These methods are in accordance with those set forth by the OECD Transfer Pricing Guidelines, which are:

a) Uncontrolled comparable price, consisting of considering the price or compensation that would have been covenanted with or between unrelated parties in comparable operations.

b) Resale price, consisting of determining the acquisition price of an asset, a service or a compensation for any other operation between related parties, by multiplying the resale price or that of the service or operation concerned, as established with or between independent parties in comparable operations, by the result determined by subtracting from a unit the percentage of gross profit which would have been covenanted with or between independent parties in comparable operations. The percentage of gross profit shall be computed, for purposes of this Section, by dividing gross profit by net sales.

c) Cost-plus, consisting of multiplying the cost of the goods or services or of any other operation, by the result determined by adding to unity the percentage of gross profit which would have been covenanted with or between unrelated parties in comparable operations. The percentage of gross profit shall be computed, by dividing gross profit by cost of sales.

d) Profit split, consisting of assigning the operating profit obtained by parties related to each other, in the proportion thereof that would have been assigned with or between independent parties, as follows:

i) The aggregate operating profit shall be determined by adding the operating profit obtained by each person so related involved in said operation;

ii) The aggregate operating profit shall be assigned to each person, by considering elements such as the assets, costs and expenses of each person thereof in respect of operations between said related parties.

e) Residual profit split, consisting of assigning the profit obtained in the operation by the parties related to each other, in the proportion, which would have been assigned with or between independent parties.

f) Transactional margin of operating profit, consisting of determining, in operations between parties related to each other, the operating profit which would have been obtained by comparable enterprises or by independent parties in comparable operations with basis on yield factors in which account is taken of variables such as assets, sales, costs, expenses and cash flow.

The Mexican tax authorities have powers granted by law to audit Mexican taxpayers. Companies that are found to have failed to follow the transfer pricing rules may be subject to sanctions.

Tax Compliance Certificate

Mexico’s Federal Tax Code authorizes and, in specific cases, requires Certified Public Accountants who fulfill certain requirements to issue audit certificates on companies' financial statements for tax purposes, similar to certificates issued for financial purposes. These certificates must contain a series of exhibits that show detailed tax information and comparisons as well as adherence to professional standards.

The statements in the certificates issued by Certified Public Accountants are considered valid by the tax authorities, and thus direct audits may be avoided. However, although it seldom occurs, the authorities have the right to directly review the company in spite of an existing certificate if valid reasons exist.

Social Security law also requires Mexican employers to have an authorized Certified Public Accountant audit their social security contributions. This may reduce the possibility of a direct audit from the Social Security authorities.

With the same purpose, certain local Governments, among them Mexico City’s, urge corporations to submit their local taxes and contributions (such as payroll tax, land tax, etc.) to a review by a Certified Public Accountant.

6. TAXATION ON INDIVIDUALS

Territoriality and Residence

An individual is considered to be a Mexican resident for tax purposes if he or she has a permanent home in Mexico and if he or she spends more than 183 days (consecutive or not) in Mexico during any given calendar year. These provisions, however, do not resolve all tax residency issues, since an individual, according to another country's legislation, may be resident for tax purposes in that country.

Mexico’s tax treaties with other nations provide for the resolution of such controversies. Residency is considered to be the country in which an individual has a permanent home, or keeps closer economic and personal ties, or maintains nationality. In extreme cases, the governments of the involved countries must resolve the controversy through negotiation.

When a non-treaty country is involved, special government negotiations must be conducted.

Taxation on Resident Individuals

Resident individuals are subject to income tax on their annual taxable income. Taxable income is determined by adding together the various categories of income and deducting losses and expenses.

Income categories:

* Salary

* Additional compensation (such as housing and children's education) attributed to salary

* Professional fees

* Real State rental and disposition of goods

* Acquisition of goods

* Interest, prizes and others

* Commercial activities

In determining income tax there are certain deductions that apply to family and dependents, including: medical and dental expenses, funeral expenses, donations to duly authorized institutions, and school transportation (where obligatory).

Taxation on Non-Resident Individuals

Non-resident individuals are taxed on the following income categories:

* Salary for personal services rendered in Mexico (whether paid by a Mexican or foreign resident)

* Professional fees for services rendered in Mexico (whether paid by a Mexican or foreign resident)

* Leasing or sale of goods

* Sale of real estate

* Sale / acquisition of stock

* Interest

* Construction, installation and maintenance activities

* Prizes

* Public and sports shows

Most of these types of income are taxed with withholding rates fluctuating from 4.9% to 35% applied on the gross income. In some cases, the income tax rate may be applied to the net profit of the operation, if certain requirements are fulfilled.

Most of the tax treaties entered into by Mexico provide that taxes derived from Mexican source income for individuals will only be taxed in Mexico. In other cases, foreign tax credit may be applicable.

7. INVESTMENTS IN LOW TAXATION JURISDICTIONS (“TAX HAVENS”).

The Mexican tax reforms in force as of January 1, 1997 provide special rules whereby profits generated by investments in “tax havens” will be treated as taxable income in Mexico, regardless of whether such income has been distributed to the taxpayer.

The Mexican Income Tax Law also considers as taxable income the profits from an investment in a low taxation jurisdiction when the investment is made through:

- Branches or related entities of the taxpayer, regardless of whether they form part of the taxpayer’s financial system;

- the holding of shares, bank or investment accounts and any form of participation in trust, joint ventures, investment fund or similar legal or paralegal figures created or incorporated under foreign law; and

- a third party for the benefit of the taxpayer.

Tax Havens

As defined in Mexican tax law, tax haven jurisdictions are the following:

· Countries that do not tax the revenues obtained by its residents, regardless of whether or not the revenue is from a source of wealth in that country.

· Countries with low tax rates.

· Countries which exempt tax on revenues obtained from a foreign countries.

· Countries with tax benefits for certain investments.

Please contact us for a current list of the jurisdictions considered tax havens under Mexican tax law.

Obligations

Mexican taxpayers with investments in Tax Havens have the following obligations:

· Report as taxable income on their annual income tax return the profit obtained from a direct investment.

· Prepare and file a return reporting their direct and indirect investments. Failure to comply with this requirement may result in the assessment of criminal tax evasion. ·

Accounting

A taxpayer must make the accounting of such investments available to the Mexican tax authorities. The accounting must: (i) it must be in Spanish or to have a translation by a legally authorized expert translator, (ii) the records have to be in Mexican pesos or they have to convert the amounts to Mexican Pesos, (iii) it must be retained for five years.

Taxpayers who comply with the above requirements will be able to: (i) take applicable deductions and amortize losses, and (ii) not accrue the dividends distributed by investments in tax havens to the profits subject to taxation in Mexico.

8. FOREIGN TRADE

Foreign trade legislation offers incentives for import and export of goods into and out of Mexico. The following is a brief description of these incentives:

In-bond Industry (Maquiladora)

Maquiladoras are assembly plants operating in Mexico under special customs treatment and foreign investment regulations. These types of companies import machinery, equipment, parts, raw materials and other components for the assembly or manufacture of semi-finished or finished products duty free, on a temporary basis, into Mexico. These products are then exported back to their country of origin or to a third country.

As specified by regulations of the Harmonized Tariff Schedule, 95% of the components used in the Mexican maquiladora industry are from the U.S.

The Ministry of Economics is the governing agency of the maquiladora program and is where authorizations are requested. The term of the maquiladora program is not specified in legislation or in the government approval. No periodic updates are required. However, the authorization may be terminated at any time.

"Sub-Maquila" operations may also be authorized by the Ministry of Economics, provided they are complementary to the main production process.

Maquiladoras may sell their products on the Mexican market as well. However, preferential tariff benefits received on imported component parts are subject to recapture for such domestic sales.

Maquiladoras are subject to the same tax regulations as any regular corporation. However, Under Mexican law in force as of January 1, 1995 all maquiladoras are subject to specific transfer pricing rules, basically the principle that intercompany transactions between the foreign company and the Mexican company must conform to arm’s length transactions between third parties.

Temporary Import Programs

Mexico maintains import programs under which businesses may import raw materials or goods duty-free, provided they are eventually exported, either in the same condition or as components or materials of other goods. Machinery related to export manufacturing may also be imported duty free under these programs.

The main temporary import programs for manufacturing activities are the "Program for Temporary Import of Goods" (PITEX) and the "Program for High-Exporting Corporations" (ALTEX). For commercial or distributing activities, the "Program for Foreign Trade Corporations " (ECEX), "Draw back" and "Cuenta Aduanera" (Customs Account) may apply.

On May 11, 1995 the SECOFI published a decree by which corporations without a temporary import program may request refund of the taxes they paid when they imported materials or goods, provided that these materials or goods were eventually exported.

North American Free Trade Agreement (NAFTA)

The North American Free Trade Agreement (NAFTA) between Canada, Mexico and the United States of America went into effect on January 1, 1994. NAFTA is the largest market worldwide with an estimated consumer potential of 370 million people.

The objectives of NAFTA are to eliminate commerce barriers, promote conditions for fair competition, increase investment opportunities, provide adequate protection for intellectual property rights, establish effective procedures for the treaties application and trilateral cooperation (regional and multilateral) between the three countries.

NAFTA foresees elimination of tariffs on goods with country of origin in Canada, Mexico, or the United States within a transition period. Rules of origin are necessary to determine which goods are eligible to receive NAFTA's benefits. The rules of origin may require detailed analysis of an imported product to determine whether NAFTA tariff benefits are available. However, the general principle is that goods are considered to be originating from a NAFTA country when they are primarily produced in Canada, Mexico or the United States (North America). In some cases, goods containing non-NAFTA materials may also be considered as originating from a NAFTA country.

The NAFTA schedule for elimination of tariff and commercial barriers has moved ahead steadily since 1994. There remain controversies in certain sectors, such as trucking and agriculture, however.

Following the current trends of economic globalization, Mexico has negotiated and entered into a growing number of free-trade agreements, not only with countries of the Western Hemisphere, but also with the European Union and Asia. These treaties increase the possibility that U.S. and Canadian businesses may use Mexico as a production platform for export and trade with these nations.

For additional information please contact:

FERNANDO RIVADENEYRA
RIVADENEYRA,TREVIÑO Y DE CAMPO, S.C.
31 PONIENTE 4128, 9 PISO, COL. AMPLIACION REFORMA
PUEBLA, PUE. 72160
TEL. 011 (52) (222) 249 88 28
FAX. 52 (222) 249 23 61
E-Mail: frivadeneyra@rivytrev.com.mx

DAVID SPENCER
ATTORNEY AT LAW
1621 LAKE MOUNT DRIVE
SNOHOMISH, WA. 98290-1730
TEL 360.862.9101 or 206.650.7048
FAX 206.508.3999
E-mail: spencer@davidspencerlaw.com