New NAFTA Alliances Reshape Sourcing Scene

While "doing some work in Mexico" was almost always arm's length business in the past, sourcing in Mexico today means serious commitments and close communications for firms on both sides of the border.

the apparel industry -- perhaps the most globalized and internationalized of all manufacturing sectors -- is experiencing the emergence of a significant trend toward the regionalization of trade and production. Driven by a variety of factors from trade liberalization to demand for quick-turn service, this movement has led to the growth of regional apparel nerve centers, as well as complex transnational sourcing alliances.

Consider that approximately 75 percent of the apparel trade in the European Union is intraregional, and that most of Japan's textile and clothing trade takes place within the Asian region. Likewise, the Western Hemisphere has come to constitute a formidable sewn products production arena, in which Mexico is the rising star.

Undoubtedly the North American Free Trade Agreement (NAFTA) has spearheaded economic regionalization in the Americas. In fact, between 1995 and 1998 Mexican apparel exports to the United States increased 119 percent, surpassing those of Hong Kong, China, South Korea and the combined Association of Southeast Asian Nations (ASEAN) region.

This article profiles the dynamic sourcing scene in North America, with an emphasis on the interesting evolution of apparel production alliances between firms of the United States and Mexico.

Beyond the 807 Paradigm

Prior to NAFTA's inception, avenues available to U.S. apparel manufacturers for Mexico sourcing were limited to 807-based production sharing arrangements, now classified under the 9802 tariff regulation. Although the level of capital investment in Mexico on the part of U.S. lead firms [*] varied, commitment to Mexican sourcing was often short term and Mexico-based production generally represented a small percentage of the U.S. companies' overall production.

Well more than 90 percent of U.S. apparel imports from Mexico before NAFTA were "re-imports," in other words, garments assembled of pre-cut pieces that had been shipped to Mexico by U.S. firms under the 807 (9802) regulations. More importantly, U.S. garment firms often pulled back from Mexican sourcing arrangements, citing a laundry list of complaints ranging from poor quality, inconsistency, long lags in turnaround, communications problems and mountains of bureaucratic red tape.

However, this picture has been rapidly changing since NAFTA's implementation. Consider the following: In 1998 Mexican apparel exports to the United States alone exceeded US$6 billion, three and one-half times greater than Mexico's 1980 maquila output of all manufactured goods. As of late 1997, Mexico ranked first in apparel exports to the United States and second only to Canada in the export of textiles.

The linchpin of Mexico's sewn products exports -- its maquiladora system -- grew from about 100 registered plants in 1980 to about 2,000 in 1994, across all industries. This number skyrocketed to 3,000 this year, and significantly: One-third are apparel factories.

There also has been a tremendous shift of activities between U.S. and Mexican firms that is not simply quantitative in nature (i.e., more assembly). Rather, there are more long-term commitments on both sides of the border, increased integration of operations between trading partners, and improved sophistication of production in Mexico. Moreover, Mexico has experienced the growth and maturation of garment-specific industrial clusters in its different regions and states.

According to U.S. Department of Commerce figures, Mexico's nonmaquila apparel exports to the United States as a proportion of total apparel exports have doubled, suggesting a shift to more full package production. (The United States' Caribbean Basin trading partners have not shared in this surge in non-9802 apparel exports; in fact, non-9802 U.S. apparel imports from the Caribbean Basin nations have decreased.)

The Emergence of Transnational Regional Networks

As NAFTA revamps the North American apparel commodity chain, the textile and apparel industries of the region have moved toward integration, and in turn, generated cross-border regional production chains. The principal nerve centers of these chains appear to be emerging in the U.S. Southeast, through the mill-driven strategies of the textile giants [1], and in Southern California, driven by hundreds of mid-to large-sized apparel manufacturers and designers [2]

From the Southeast, Guilford Mills Inc., Cone Mills Corp. and Burlington Industries, along with other textile firms, have initiated major forays into Mexico. They are forming alliances and building infrastructure that will enable them to offer "mill-direct" apparel. (See "U.S. Mills Move South," page 44.)

From Southern California, the number of larger apparel manufacturers sourcing in Mexico has increased four-fold between 1992 and 1998. And during the past 18 months, both the number of firms and the proportion of their production sent to Mexico have continued to grow at a healthy pace.

In looking at the competitiveness of both of these U.S. production hubs, Bruce Berton, a business consultant with the accounting and consulting firm Stone-field Josephson, suggests it's a close match. Nonetheless, he believes the region capable of handling the intricacies of fashion will take the lead.

"I don't think the Burlingtons of this world have enough hands-on experience to pioneer [fashion-forward production] ," observes Berton, whose firm serves more than 200 sewn products industry clients. "It's a toss-up. But Southern California, because it has so many independent manufacturers, is going to be the hub. ... Southern California [will] become the Hong Kong, and the gateway to the Americas."

The Makeup of the Modern Strategic Alliance

Even as it has propelled the rise of new sourcing centers, NAFTA also has fostered new types of relationships between U.S. and Mexican firms. As such, opportunities abound for U.S. lead apparel firms and their Mexican affiliates to move beyond the old arm's length cross-border production sharing agreements to shoulder-to-shoulder transnational production alliances.

These alliances differ from pre-NAFTA production sharing relationships in that they involve larger investments of time, money and personnel, and closer monitoring of the supply chain by the U.S. lead firm. In sum, the new production alliances represent a higher level of long-term organizational and transnational interfirm integration.

For example, Los Angeles, CA-based Garment Services International (GSI), a private label manufacturing firm, keeps in close contact with its northern Mexico factories through regular site visits and state-of-the-art communications. GSI has a strong director of operations living in Tiajuana, Mexico, and the firm monitors production through the Internet.

According to Jim Reach, president and co-owner of GSI, "With the new [computer] system our production people on this end are better able to have a partnership with our factories. We know how to properly feed work [to the Mexican factories] and how our efficiencies were for a day." The bottom line, Reach emphasizes, is that you have to "treat Mexican business just as you would treat your business in the U.S."

For a U.S. firm, the NAFTA-driven strategic sourcing alliance can encompass an array of creative production arrangements strategized to suit the firm's size, lines and price points, as well as the specific needs of its clients. Likewise, Mexican apparel and textile firms have become more important players in North America's new transnational networks, especially as U.S. textile firms, apparel manufacturers and retailers seek to exploit NAFTA to capture and/or extend control over segments of the apparel production chain. As a result, more Mexican firms have been able to upgrade their operations as they are incorporated into the world-class production networks of major U.S. firms.

Types of Alliances. A couple of ways to categorize the new breeds of NAFTA production alliances is by 1) the corporate/legal relationship between the U.S. company and its Mexican affiliate; and 2) the cross-border distribution of pre-production and production activities. Typically, the financial interests for U.S. companies include, but are not limited to: capital investment in a maquiladora; shared ownership of production facilities; or the establishment of a wholly owned subsidiary in Mexico.

Often, but not always, the level of U.S. investment in Mexico is related to the level of production activities. Some companies, such as Los Angeles, CA-based Tarrant Apparel Group, have made a big push into Mexico, with enormous outlays of capital. These firms often are shifting a significant percentage of their overall production to the country, and buying or establishing vertical company-owned operations, from textile mills to cut-make-trim (CMT) facilities.

In Tarrant's case, its wholly owned Mexican subsidiary, TAMEX, oversees the firm's distribution of goods from Mexico and Central America. In the past 18 months, TAMEX has acquired a large denim mill, a twill factory and a distribution center in the state of Puebla, and the Grupo Famian garment contracting operation in the Puebla municipality of Tehuacan. Tarrant's close relationship with the latter figured prominently in its decision to acquire the facilities. As CEO Gerard Guez told Bobbin: "We knew Grupo Famian operated with a lot of efficiency so it made sense [to purchase it]."

Along the way, Tarrant has internalized practically all production activities, affording it full package capabilities in Mexico. According to Guez, "Verticalization is on track -- ahead of time."

More often, U.S. firms' strategic alliances in Mexico are anchored by capital goods interest, partnership interest or the establishment of a CMT subsidiary in Mexico. These types of alliances can come in all shapes and sizes, with players on both sides of the border creatively jockeying for a competitive position.

For instance, one Los Angeles manufacturer has moved full-steam-ahead into full package production in Mexico through a unique "sister-factory" strategy. The firm, which produces licensed goods for a very large Southern California manufacturer/marketer, convinced several of its U.S. sewing contractors and stonewashing specialists to open factories in Mexico. Thus the manufacturer, which is an investor in the Mexican facilities, is able to continue working with contractors that understand its processes and requirements, while taking advantage of low Mexican production costs. Turnaround times are between six weeks to seven weeks for full package orders.

Still, the arrangement isn't without challenges. One of the CMT facilities, located in Mexico's interior, has hit supply chain snags ranging from fabric/marker discontinuities to late deliveries from the United States to worker retention. Unfortunately, such obstacles are common among firms venturing into Mexico, though they can be minimized with careful planning. (See "Before You Go South...," page 55.)

As Stonefield Josephson's Berton sums it up: "All the things that are handled locally [in the United States] with little trouble can [turn into] a disaster when you're going across into another sovereign nation. ... Everyone thinks that their production know-how is the best. Before I take on a client, I analyze the [efficiency levels] of their pre-production and production departments. If they don't have their act together, they aren't ready for Mexico."

In conclusion, the door is open for new production alliances that can yield benefits for both for U.S. lead firms and their Mexican affiliates. However, no one benefits if the U.S. firm stumbles at the gate. Before venturing into a new sourcing alliance in Mexico, it is important to understand not only your own business structure and product cycles but also the apparel production landscape in Mexico. Know your limitations and strengths -- and plan ahead!

Judi A. Kessler, Ph.D, is an economic sociologist at the Center for U.S.-Mexican Studies at the University of California, San Diego. She currently is writing a book on NAFTA-driven transnational apparel production alliances. She may be reached at tel: 858-534-4147; or email:jukessle@weber.ucsd.edu.

Editor's Note: For more on the sourcing strategies of Tarrant Apparel Group and another major player in Mexico, Garment Services International (GSI), see Bobbin's on-line exclusive articles about these firms at www.bobbin.com

(*.) U.S. "lead firms" refers to U.S. companies that initiate sourcing relationships with Mexican firms, typically providing financing and determining many of the terms of the engagement.

(1.) For more on regional alliances and the role of U.S. textile firms in Mexico, see Gary Gereffi's article, "Global Shifts, Regional Response: Can North America Meet the Full Package Challenge?" Bobbin. November 1997, and Gereffi's and Jennifer Bair's article, "U.S. Companies Eye NAFTA's Prize," Bobbin, March 1998.

(2.) For more on the ties between Southern California and Mexico, see Judi Kessler's article, "Southern California: Transition Takes Hold," Bobbin, October 1998.

Before You Go South

What does a U.S. manufacturer need to know and do before launching into long-term production alliances in Mexico? Bruce Berton, a business consultant for the accounting and consulting firm Stonefield Josephson, offers these tips.

1 Iron out supply chain problems in the United States before venturing into Mexico.

2 Chose your Mexican region of production in an informed manner. Relations with local producers mean everything, and apparel production centers are becoming garment-specific, with maquiladora capabilities varying both within and across municipalities and states.

3 Take an honest inventory of your production cycles in order to give your Mexican affiliate sufficient lead time to plan and carry out production. Under Mexican law, employees are paid for downtime, which is a great fear of the Mexican manufacturer. Add at least 20 percent more time to your production timetable in order to effectively meet your calendar date deliveries.

4 Understand that U.S.-Mexico strategic production alliances don't happen overnight. Allow six months to 18 months -- and substantial investments in time, personnel and other resources -- to realize an efficient supply chain between Mexico and the United States. Station personnel in Mexico for the short term, or at least make a number of trips to the production site to establish effective communications, and to monitor quality, work conditions and the capabilities of Mexican affiliates.

5 Additionally, notes author Judi Kessler, keep abreast of Mexican politics at the federal level, and especially at the level of the state in which you source your production. Remember, NAFTA is a trade law, not a tax law. Rules governing land use, utilities, subsidies, relations with Mexican companies and corporate and income taxes are subject to change.

Mexico Tax Reform Exposes U.S. Apparel Firms to 'Double Income Tax'

The Mexican government has passed tax reform legislation, scheduled to take effect Jan. 1, 2000, that could drain the profits of many U.S. apparel firms that are sourcing in Mexico.

The tax reform package, dubbed the "Permanent Establishment" law, includes new rules that permit the Mexican government to tax income and profit generated in the United States by U.S. manufacturers that produce in Mexican maquiladoras and Programa para la importacion (PITEX) [1] companies, or engage in other shared production activities in Mexico.

In essence, U.S. firms may end up paying "double income tax" -- to the U.S. Internal Revenue Service (IRS) and the Mexican Treasury -- on a portion of their earnings.

The Mexican government's position is that U.S. firms, by exploiting Mexico's low production costs, are realizing greater profits in the U.S. market than they would if their product was manufactured in the United States. As such, under the new law, Mexico has changed the criteria that define a "permanent establishment" for tax purposes. U.S. companies whose Mexican production operations meet the new criteria will be taxed by Mexico on the U.S. profit realized from maquiladora or PITEX production.

Closely following the progress of and debate surrounding the implementation of the Permanent Establishment reform is attorney Juan Zuniga of San Diego, CA-based Baker & McKenzie. Harvard-educated, Zuniga is an expert in the area of international trade and corporate and securities law. He recently discussed the structure and impact of the new Mexican tax rules with Bobbin.

Note: All figures are in U.S. dollars.

BOBBIN: Why was Permanent Establishment legislated?

ZUNIGA: Mexico has had some very difficult economic times since 1994/95. On top of its currency crisis, economic crisis and banking crisis, there has been a very serious depression in worldwide petroleum profits. Common sense tells you that this is a method of generating new revenues [for the Mexican government].

BOBBIN: Who will be affected by Permanent Establishment?

ZUNIGA: The law applies [to U.S. manufacturers], no matter what the corporate relationship is between the U.S. and Mexican firm. But it only applies to U.S. parent companies. If you are a parent company [from another sovereign country], permanent tax is not going to apply.

BOBBIN: Why does the law apply only to U.S. companies?

ZUNIGA: Because of a quirk in the U.S.-Mexico tax treaty.

BOBBIN: How is the tax law structured now, before the implementation of Permanent Establishment?

ZUNIGA: Every country has transfer pricing laws. In Mexico, if a U.S. parent company engages a third party [for] manufacturing services, it pays costs, plus 4 percent to 7 percent above the cost, which is deemed to be an "arm's length" or fair market profit. For example, if your costs of production are $1 00,000, your "cost-plus" [with the profit allowance] would be about 5 percent--$5,000--and would be taxable in Mexico at the corporate rate of 35 percent--$1,750. However, the U.S. company can write off the costs and cost-plus, and receive U.S. foreign tax credit for the $1,750.

BOBBIN: What if subcontractors are utilized by the Mexican affiliate?

ZUNIGA: Subcontractors are just a cost that gets factored into what the Mexican firm has to pay for labor and other costs. They go on the expense side of the ledger.

BOBBIN: What changes will the industry see in the year 2000? How will Permanent Establishment work?

ZUNIGA: With the new tax rules, a U.S. firm will be deemed to have a permanent establishment in Mexico for tax purposes if: 1) the U.S. parent company provides inventory, raw materials for production, to a Mexican factory; 2) the [Mexican] factory is a dependent agent of the U.S. company [i.e., an exclusive arrangement exists]; and 3) the U.S. parent owns or provides the means of production [i.e., capital equipment or other assets]. ... This means you have a taxable presence in Mexico. You are generating income and profit in Mexico, and you are going to be taxed on that income and profit in Mexico.

BOBBIN: Can you offer a hypothetical example?

ZUNIGA: Assume the U.S. apparel company paid $105,000 for production [in Mexico], including transfer pricing costs, and turned around and sold the finished garments for $205,000 in the United States -- for a real profit of $100,000. The profit that the U.S. firm realized from the productive activity in Mexico will be taxed at the Mexican corporate rate of 35 percent. Because it is a tax applied against the U.S. company, it is not, for IRS code purposes, a foreign tax-creditable tax. So in addition to the U.S. 40 percent corporate tax -- $40,000 -- Mexico is going to charge you [an additional] 35 percent -- $35,000. Your total tax on your $100,000 profit is $75,000. You essentially have had your tax almost doubled, and your profit has now evaporated down to $25,000. That's a really heavy-duty cut into your margins. This is what is supposed to happen if this permanent establishment rule stays in place and is effective, beginning Jan. 1, 2000. Now that's spooky stuff.

BOBBIN: What are the alternatives available to a U.S. company to avoid permanent establishment in Mexico?

ZUNIGA: Break the three-part formula, one of the three links in the chain, to get out of permanent establishment. Source inventory from Mexico, break the dependent agent chain or have the Mexican company provide its own means of production. For example, there is no permanent establishment if your Mexican [affiliate] is providing the raw materials.

BOBBIN: Effectively, the new rules would advance full package operations in Mexico.

ZUNIGA: Full package production would be one way out, although it is difficult to finance in Mexico currently. The indigenous banking system is a mess. For most companies, breaking [the first link] is not going to work.

BOBBIN: What about breaking the "dependent agent" relationship?

ZUNIGA: You could set up your Mexican maquiladora--even if you own it 100 percent -- as a fully-independent company. You make a real set of negotiations for manufacturing services between your subsidiary and your parent, and perhaps allow your Mexican subsidiary to take in other work. [But] most people in the garment industry today are trying to get exclusives, tighter alliances. They are looking for long-term, consistent, efficient production with a proven contractor. And they want to protect their source of production from their ultimate buyer -- Sears, JCPenney, Wal-Mart -- the retailer.

BOBBIN: What about breaking the third criterion, which would require the Mexican affiliate to own or provide its own means of production?

ZUNIGA: The Mexican subcontractor can start buying or leasing its own sewing machines. But how is it going to pay for them? Who is it going to get its equipment from? Are you going to have equipment financiers in Mexico? The cost of financing in Mexico is easily four times to five times higher than in the United States. You could have the U.S. company provide sufficient capital or [forward] a loan. But when the Mexican company pays interest back to the United States, that's income generated in Mexico, and it's taxable. These are issues that need to be addressed. In addition, there's a 1.8 percent asset tax in Mexico. If the Mexican company owns its equipment, it will be subject to the asset tax. If the majority of your productive assets are the machines that you work with, things start to add up very quickly. Hopefully, the asset tax is less than the tax on the profits.

BOBBIN: How will the profit generated in Mexico be calculated? For example, doesn't marketing come into play in profit enhancement?

ZUNIGA: Exactly. Isn't it a nightmare, a headache, to figure that out? Think about what Mexico will be up against to try to establish or prove what part of the [hypothetical] $100,000 profit is related to Mexican production activities. And it will add layers of bureaucracy and cost onto [the U.S. company's] internal processes, above and beyond the 35 percent tax. It starts costing more and more, the more you think about it.

BOBBIN: How is Mexico going to enforce the Permanent Establishment law?

ZUNIGA: That's another interesting question. The last piece of the equation that's really ambiguous is how the Hacienda [the Mexican Treasury] can cross the border into the United States and tax a U.S. company.

BOBBIN: In terms of this law, what is the level of awareness on the part of U.S. apparel manufacturers?

ZUNIGA: I think it's very low. Those who are most aware are the big manufacturers who have sophisticated counsel and tax practitioners who know the bottom line. This isn't big on the radar screen for companies that are making $10 million to $50 million in sales because they aren't engaging tax advisors that play in the international realm. There are accountants in the U.S. who aren't aware of this issue.

BOBBIN: What, if any, lobbying efforts are being executed to block Permanent Establishment?

ZUNIGA: Last August a group from the Western Trade Association was at Los Pinos, meeting with [President] Zedillo. Mexico is of the opinion that the Permanent Establishment tax rule is not that big of an issue. The Mexican government doesn't think it should lead to double taxation, and is talking to the IRS authorities to see if it can make this 35 percent tax a foreign tax credit. But they [the Mexican government] really are not budging. Basically, they are stalling on it.

BOBBIN: What do you think will happen with regard to the law come Jan. 1, 2000?

ZUNIGA: I think there is a good likelihood that, at the end of the day, come Dec. 31, 1999, [Mexico] will put a moratorium of one year on the imposition of this law. But [if it does], it will do it at the last minute. So many of our clients are going to have to have some change in place going into the year 2000. Otherwise, they will be in big trouble. I think we are going to see a lot of companies evaluate what model for change is most appropriate for them, and try to implement it in time. It won't be easy.

(1.) PITEX is an export promotion scheme originally created for Mexican export firms. Like the maquiladora program, PITEX allows for duty-free imports of some raw materials and capital goods.

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