A controversial proposal to block foreign providers of digital services from offering their services in Mexico if they fail to comply with Mexico’s digital tax rules has just been signed into law. The scope of the law is broad enough to encompass a whole host of digital services that individuals and businesses consume everyday—from streaming and dating services to online shopping, and virtually anything that exists in the cloud. The economic costs could also be severe—for example, blocking access to YouTube for a single day would cost the economy $18 million USD. As the world pulls itself up from the economic shock of COVID-19, Mexico’s latest action has the potential to dampen recovery efforts, and also to further strain U.S.-Mexico relations.
On December 8, 2020, President Andrés Manuel López Obrador approved the law despite numerous concerns raised about whether the new measure is in breach of Mexico’s obligations under the U.S-Mexico-Canada Agreement (USMCA). His action marks an open provocation of U.S. business interests, as well as Mexican consumers of foreign digital services. Taking a look at the content of the law, it becomes clear that this issue should be high on the incoming U.S. Trade Representative’s agenda, for it is likely to not only violate the USMCA, but also many core principles of digital trade governance the United States is hoping to replicate in other agreements.
Why does Mexico want the power to block foreign service providers from providing services in Mexico over the internet?
Mexico enacted changes to its value-added and income tax laws as part of the FY2020 budget proposal, which resulted in certain non-resident (foreign) digital service providers becoming liable for paying its value added tax (VAT). In some cases, platforms such as Airbnb would also have to withhold and surrender income taxes. Digital service providers must also comply with a series of administrative requirements, including registering with the Mexican Tax Administration Service (SAT), designating a legal representative and address on Mexican soil, and processing their advanced electronic signature. Since these changes went into effect on June 1, 2020, 48 foreign digital service providers have obtained registry under the SAT.
When these new rules were first proposed in October 2019, the Ministry of Finance began floating what is referred to as the “kill switch” mechanism, a tax enforcement tool that would essentially block Mexican consumers from having online access to digital services from a company that is purported to not be in compliance with Mexican law. For example, say YouTube was not in compliance with the law—the kill switch would allow the Mexican tax authorities to order YouTube to be blocked—if someone in Mexico tried to access the site on her internet browser, the site could not be viewed.
The Ministry of Finance proposed the kill switch as an enforcement tool because it argued that the new tax obligations would not be effective in achieving compliance with the laws on their own. But the mechanism was ultimately struck from the proposed reforms to Mexico’s tax laws, following amendments submitted by deputies from multiple parties. The issue seemed resolved for the time being.
Then, in the fall of 2020, as discussions were underway for the FY2021 budget, the kill switch was brought up again, but no evidence was provided to support the claim that the current tax law was insufficient in assuring compliance. Despite this, the Finance Commission of the Mexican Chamber of Deputies supported the inclusion of the kill switch and also proposed to extend it to the Income Tax Law.
This time, the kill switch was passed by the Chamber of Deputies and left untouched by the Senate. Following modifications to other aspects of the bill by the Senate on October 29, 2020, it returned to the Chamber of Deputies and was ratified on November 5, 2020. With AMLO’s signature on December 8, 2020, the kill switch will enter into force under both the VAT and Income Tax Laws on January 1, 2021.
How does the kill switch work?
If a foreign digital service provider is noncompliant with Mexican tax laws, the SAT (tax authority) can publish an order to block access to that service on the internet for people in Mexico. Examples of non-compliance are: if a service provider fails to pay its tax bill, misses consecutive deadlines for reporting information on returns, or if it fails to meet a number of other administrative requirements, such as voluntarily registering under the Federal Taxpayer Registry, designating a legal representative and address within Mexican territory, or failing to process its advanced electronic signature.
Once the order to block access to a foreign provider has been published, the respective network carriers (the internet service providers) will be notified, and they must carry out the order within a period of five days.
The foreign provider has a right to reply to the order, and is granted a period of 15 days (with a one-time, optional five-day extension) to bring itself into compliance with its tax obligations, or alternatively, to justify its non-compliance. In the case of the latter, the tax authority would evaluate the information provided within 15 days, and either issue an extended deadline for compliance or proceed with the decision to block said provider’s access to the internet. This very short period of time to respond could potentially make compliance difficult, particularly for small and medium-sized enterprises that do not have the same resources as larger companies.
But, generally speaking, the whole process by which the kill switch may be implemented is quite vague, and it is not clear how it will actually work in practice. For instance, it appears to place a lot of power in the hands of the tax authority to take the decision to employ the kill switch, but the details of how an investigation would be initiated, and what that would entail remain uncertain. It is also unclear how the tax authority would coordinate with internet service providers, and even how the over 400 internet service providers in Mexico would coordinate among themselves to actually block the service provider’s access.
The technical specifications of how the kill switch will be implemented are not laid out in the law, casting a large cloud of uncertainty over both providers and end-users of digital services. There are many ways to block access, all of which have a number of challenges to implement. Contrary to how the kill switch has been described—as an on and off switch for noncompliant companies—it’s actually not that straightforward. Say, for instance, that a payment processing service is blocked, and can no longer process transactions. Small businesses rely on third-party payment processing all the time—think of when you’re shopping online and you proceed to check out, and your payment is processed by PayPal, or redirected to another site. Imagine the impact if all of a sudden the payment processing service isn’t working. Not only is the company that was originally targeted hurt, but many more can be impacted in the process. The technical precision required to block access for a single provider is incredibly complex and easy to get wrong. In taking out one shop, internet service providers could end up shutting down an entire mall.
And, since many sites are housed within cloud services, blocking one could have ripple effects that take out many others in the process, impacting the broader internet ecosystem. The overall lack of transparency in the procedural requirements of applying this enforcement mechanism warrants scrutiny, as the lack of detail raises serious questions about government regulation of the internet and also makes it potentially ripe for abuse.
Does the kill switch breach the USMCA?
There is strong opposition to the kill switch, both in Mexico and abroad. Trade associations from all USMCA partner countries and elsewhere in Latin America sent a letter to the leaders of the Mexican Congress on October 23, 2020, arguing that the measure was not only inconsistent with Mexican law, but also with the USMCA. With regard to the USMCA, the trade associations argue that the measure is inconsistent with Article 15.3 (National Treatment), Article 18.3 (Access and Use), and Article 19.10 (Principles on Access and Use of the Internet for Digital Trade).
It is certainly possible that the measure could be in violation of Article 15.3 of the chapter on Cross-Border Trade in Services because it appears to apply a unique enforcement tool to foreign service providers. Since the kill switch cannot be applied to domestic service providers, a case could be made that the measure is, on its face, discriminatory. In addition, it could be argued that the tax registration rules that require foreign service providers to designate a legal representative and address on Mexican soil could violate Article 15.6, which prohibits such local presence requirements “as a condition for the crossborder supply of a service.”
If the kill switch is employed, it could also be in violation of Article 18.3 of the Telecommunications chapter, which requires USMCA partners to “ensure that any enterprise of another Party has access to and use of any public telecommunications network or service, including leased circuits, offered in its territory or across its borders, on reasonable and non-discriminatory terms and conditions.” While Mexico may try to make the case that employing the kill switch is reasonable to enforce its tax laws, it will have a hard time showing that it is non-discriminatory, as noted above. Furthermore, it does not appear that the kill switch would fall under any of the exceptions of this chapter, such as those that governments can take to protect the privacy of personal data. Taking action to restrict internet access on the basis of tax-related issues does not, therefore, appear justified under the terms of the USMCA.
Finally, the measure could be in violation of the USMCA’s digital trade chapter, the most comprehensive of any trade agreement. It would likely violate Article 19.4, which requires the parties to the agreement to treat foreign and domestic digital products in the same way—meaning, that a government cannot discriminate against a digital product just because it is foreign. There is also a possible claim to be made with regard to Article 19.11 that prohibits restrictions to the free flow of information between the parties. A similar provision under the Financial Services chapter, Article 17.17, could also potentially be raised as well.
Article 19.10 might be the more difficult claim to litigate because the language of this provision does not create a binding obligation on the parties; rather, it simply states principles they recognize as important. It would be interesting to see how a USMCA panel would rule on this issue, but it appears that there are many other viable claims of violation that could be made against the measure.
What will happen next?
It is always important to keep in mind that violating trade rules does not automatically trigger action. And, at the moment, Mexico’s kill switch is not yet in force. It remains to be seen if the mechanism will ever be used. If it is, the repercussions could potentially be quite significant.
At a time when we feel reliant on digital services more than ever, with so many people around the world working and running businesses from home, the potential impact of implementing the kill switch could be severe. The measure would undoubtedly place a burden on businesses, particularly small and medium-sized enterprises that rely on digital services. When so many people are struggling from the economic shock brought on by the COVID-19 pandemic, it seems counterproductive for Mexico to take any action that would hamper their recovery, including disrupting access to foreign digital service providers.
Service providers and the businesses and consumers that rely on their services should continue to push for reform in the hopes that the government will ultimately remove the kill switch from the law. In addition, some have suggested that Mexico should bring its laws into alignment with Chile’s procedures for compliance with digital service tax regulations, which are considered global best practices.
In fact, the Latin American Internet Association (ALAI), which represents U.S. and Latin American digital services providers across the region, has been vocal on this point and claims that Mexico’s process for the registry of non-resident digital services providers is the “most complex and laborious” to be observed in Latin America thus far. The Chilean regime, which also entered into force on June 1, 2020, has seen more than 105 non-resident digital service providers registering in that country (as of September 2020), compared to the 35 that had registered in Mexico at that point. As one tax expert explained, there are “examples of companies that took months to be able to prepare everything and register” whereas in other countries this process would take hours at most. Mexico’s problems with tax collection may thus have a lot less to do with a lack of compliance from foreign companies than its own internal obstacles.
It, therefore, seems difficult to justify taking such an extreme measure as the kill switch. In fact, blocking tax-owing non-resident digital service providers from accessing the internet is not employed in any other country. Mexico’s use of the kill switch could, however, encourage other countries to follow.
The unique nature of the measure could also have broader implications that are currently unseen by the Mexican government. The potential for abuse of the kill switch for purposes other than tax compliance cannot be ruled out, not least because of the lack of transparency and detail on how the enforcement mechanism will actually work in practice. In addition, restricting access to the internet in this way also raises concerns about the government’s authority to regulate the internet for a whole host of unrelated reasons—it creates a slippery slope that could usher in additional regulatory actions and abuse of power.
It is difficult to predict what will come of the kill switch, once in force. But, from examining the design and architecture of the measure, it raises significant questions about Mexico’s compliance with its USMCA obligations. The kill switch is clearly an outlier as an enforcement tool, and it would not be surprising if the U.S. moves quickly to try to push Mexico to regulate in a manner that is more in line with the rest of the world. To assure access to the internet for both providers and consumers of digital services, it would be incumbent upon the incoming U.S. Trade Representative to raise this issue with Mexico as soon as she takes office. We’ve already experienced a rocky four years in relations with one of our most important trading partners, and if Mexico goes forward with implementing the kill switch, the repercussions for this critical relationship could be much larger than policymakers ever imagined.