Performing a good due diligence is key to a successful M&A transaction. Of course, taxes are a relevant part of the due diligence, but now we should pay closer attention if one or more of the purchased entities are Mexican taxpayers with tax losses.
Mexican Congress recently passed a tax bill1 granting tax authorities new powers for challenging some abusive transactions where taxpayers allegedly conducted an undue transfer of tax losses.
According to the explanatory statements of the bill, the tax authorities detected a significant increase (258%) in the aggregate value of NOL's reported by taxpayers in 2016 vis a vis 2007, as well as in the value of the remainders of such NOLs to be used in future years (180%). The tax authorities believe that the increased tax losses may result from transactions lacking sufficient substance or sound business reasons.
Thus, in order to combat taxpayers carrying out such abusive transactions, the bill introduces a new statute, article 69-B Bis of the Federal Tax Code2, which grants the tax authority with new powers for bringing down taxpayers who may have conducted undue transfers of NOLs.
The new statute allows the tax authorities to legally presume, in some specific hypothesis that will be described below, that a taxpayer had the sole intention to unduly transfer NOL's for being (unduly) used directly or indirectly, by a different taxpayer. The consequence of this legal presumption would be to nullify the effects of the tax losses for the recipient.
The tax authorities may only apply the presumption as long as the taxpayer (1) falls in any of the six hypothesis that will be explained below, (2) has declared the tax loss(es) and (3) subsequently takes part in a restructure or deal that would entail a significant change in its (direct or indirect) shareholding structure that would allow the use of the NOLs to a person that ceases to be a part of the group to which the taxpayer who declared the NOL originally belonged to when suffering the NOL.
The tax authorities may only use the new presumptive power if it has reason to believe that the taxpayer falls in any of the following 6 hypotheses:
1. Declared the NOL in any of the three fiscal years following its incorporation in an amount that exceeds its assets and 50% (or more) of its deductions derived from controlled transactions3;
2. Declared the tax loss(es) after the three fiscal years following its incorporation and the losses derive from the fact that more than 50% of its deductions result from controlled transactions and said transactions increased in more than 50% of those carried out in the previous fiscal year;
3. Reduced its material ability to carry out its main activity in fiscal years following that in which the tax loss was declared, by transferring of all or part of its assets through a restructure, spin-off, merger or any other transfer to related parties;
4. Declared a tax loss and there was a sale of assets involving the segregation of the property rights that was not accounted for purposes of determining the (deductible) tax basis of the transferred asset;
5. Declared the tax loss while changing in any way the deduction regime for fixed or other depreciable assets before having used more than 50% of the deductible basis; or
6. Declared the tax loss and the purchase price for the (relevant) deductible items was paid (or guaranteed) by means of promissory notes or other securities that were extinguished by means of a payment form different to those authorized by the Income Tax Law4 for deductible items.
It seems that it is not the transfer of the tax losses per se what worries the tax authorities, but the possibility of artificially creating the losses. That is why the concerns are focused on relevant controlled transactions that may give rise to substantial deductible amounts, as well as other tax planning strategies that may produce significant tax losses.
In order to defend their transactions and tax positions, taxpayers should carefully document to the best possible extent that their controlled transactions pursued sound, valid and legal business reasons and that those were not conducted with the only or main purpose of obtaining a tax benefit.
When using the new presumptive power, the tax authorities shall proceed as follows:
a) When the tax authorities have reason to believe that a taxpayer may fall in one of the abovementioned hypothesis, they shall electronically inform the taxpayer;
b) The taxpayer will have only 20 working days to provide the tax authorities with the explanations, evidence and arguments to support that his transactions and resulting tax losses were legal and that it did not carry out an undue transfer of tax losses;
c) The tax authorities have a 6-month term for reviewing the explanations, evidence and arguments presented by the taxpayer. In the first ten days, the tax authorities may request additional information from the taxpayer;
d) The tax authorities shall (electronically) inform the taxpayer the results from their review (i.e. whether the information was sufficient to convince the tax authorities that the taxpayer's conduct was not an undue transfer of tax losses or not);
If the tax authorities ruling is adverse, taxpayers may challenge it by filing an administrative appeal.
At least 30 days after the ruling becomes effective, the tax authorities may include the taxpayer in the lists of taxpayers who are presumed to have unduly transferred tax losses. The lists are published in the official Tax Administration Service's website and in the Federal Official Gazette.
In addition to the public exhibition of the taxpayer who was presumed to have unduly transferred the tax losses, the lists would also have the effect of publicly declaring that the recipients of such losses are not allowed use them. If the recipients voluntarily correct their tax returns by reversing the use of such losses within 30 days following the publication, they would be entitled to pay default interest at a reduced rate. If the recipients do not voluntarily correct their tax returns, the tax authorities may initiate an electronic tax audit and assess the resulting tax liability expeditiously.
Taxpayers involved in M&A transactions involving Mexican entities with tax losses should take into consideration the effects of Article 69-B Bis of the Federal Tax Code and raise the bar for the due diligence procedures regarding those tax losses and properly assess any risks that may derive from the new statute.
- The bill was published in the Official Gazette (Diario Oficial de la Federación) on June 1st, 2018.
- Código Fiscal de la Federación.
- We use the expression "controlled transaction" to cover any deal or transaction carried on by or between related parties.
- Ley del Impuesto sobre la Renta.