Mexico deploys rules related to improper transfer of NOLs
INSIGHT ARTICLE |
In June 2018, through the addition of Article 69-B Bis in the Mexican Federal Tax Code, Mexico’s Congress published rules aimed at eliminating the improper transfer of net operating losses (NOLs) and their use by the transferee in certain transactions.
U.S. companies with Mexican subsidiaries should re-examine whether they are at risk of audit, or of losing the use of their NOLs and be subject to potential interest, penalties and fines if they have been involved in a reorganization or change of ownership. Additionally, U.S. companies involved in acquisitive transactions involving Mexican entities with NOLs should include, as part of their due diligence procedures, the assessment of any of the mentioned transactions.
In Mexico, NOLs can be carried-forward for a period of up to 10 consecutive tax years, with no carry-back allowed. Mexican tax law allows for the indexation of NOLs for inflation over time. This allowance for indexation usually results in a step-up of the amount of NOLs available for carry-forward.
In most cases, NOLs cannot be used against capital gains. As well, there are additional restrictions for the use of NOLs in reorganizations such as mergers and spin-offs.
Transferability of NOLs
NOLs, or the right to use them, are not transferable per-se. In other words, a taxpayer cannot sell its NOLs to another taxpayer. However, when a taxpayer has NOLs that are about to expire, or that can be utilized in other more profitable activities, there are two commonly used techniques to transfer those NOLs to a taxpayer or business unit that can best benefit from them:
- Transferring the stock of the corporate taxpayer1 to another taxpayer in a taxable sale, or even in a nontaxable reorganization; and
- Carving-out the business segment that generated the NOLs and then transfer the carved-out business segment to another taxpayer, either in a taxable sale, or in a nontaxable reorganization.
The provisions of Article 69-B Bis intend to combat these techniques, when they are implemented for the sole purpose of transferring NOLs.
For purposes of this article, we will refer to the taxpayer that generates the NOLs and transfers them as the Loss Taxpayer, and the taxpayer receiving the NOLs as the Receiving Taxpayer.
Article 69-B Bis provisions
Even though Article 69-B Bis became law in 2018, it contains look-back provisions where NOLs obtained in prior years2 may be affected.
In general, Article 69-B Bis establishes that the Mexican taxing authority, Servicio de Administración Tributaria (SAT), can presume that NOLs were inappropriately transferred if the Loss Taxpayer was party to a transaction such as a reorganization, merger, spin-off or a change in ownership structure, and meets one or more of the following conditions:
- Reported losses in any of the three years following its formation, in an amount that exceeds its assets, and that more than half of its total claimed deductions derive from transactions with related parties, foreign or domestic. Article 69-B Bis is silent as to what constitutes assets for these purposes.
- Has losses after the first three years following formation, when the losses are the result of deductions claimed in the tax return, and the amount of said losses are mostly (50 percent or more) derived from transactions with related parties, foreign or domestic.
- The Loss Taxpayer’s material capacity to carry out its main business activity is reduced by more than 50 percent in the tax years following the loss year, and the reduction is the result of the sale or transfer of its assets through a reorganization, merger or spin-off, or sale to a related party – foreign or domestic. Article 69-B Bis is silent as to what constitutes material capacity for these purposes.
- Has been a party to the sale to the rights of certain property, where the sale is performed through a legal vehicle that separates the actual legal ownership from the rights to use or exploit the property. These types of legal vehicles are commonly used to transfer rights to use real property or large assets.
- Changes its tax depreciation method before the accumulated tax depreciation reaches 50 percent of the original cost of the assets.
- Claims deductions in its tax returns, the payment of which is agreed upon in special financial instruments such as promissory notes, endorsement of documents, or letters of credit.
Consequences to the loss taxpayer
Once the SAT detects that a Loss Taxpayer is a party to a transaction of interest, it will notify the Taxpayer through the proper electronic mailbox3 . Upon receiving the notification, the identified Loss Taxpayer has 20 business days to provide documentation, authority and support to defend its position.
When the identified Loss Taxpayer receives the SAT notification, they should contact its tax advisors right away.
Upon receiving the identified Loss Taxpayer’s documentation, authority and support, the SAT can issue follow-up requests for additional information.
Within six months of receiving the identified Loss Taxpayer’s documentation, authority and support, the SAT will issue a letter indicating whether they agree with the Loss Taxpayer’s position or not.
If the SAT resolves against the identified Loss Taxpayer’s position, the Taxpayer may pursue appropriate administrative remedies. Legal counsel should be sought at this point.
If the Loss Taxpayer has a revoked taxpayer identification number, the SAT will remit the notification to the individual or entity that has legal authority to represent the Loss Taxpayer. This responsibility is usually borne by the appointed Tax Matters Legal Representative.
The SAT will publish in its website a list of those identified Loss Taxpayers that have failed to defend their position, and are therefore deemed to have transferred NOLs in an inappropriate manner. This publication will serve as a notification to the Receiving Taxpayers that they are in possession of inappropriately transferred NOLs.
It is highly likely the SAT will initiate full audit procedures on those identified Loss Taxpayers that fail to defend their position and that appear in the SAT’s list.
Consequences to the receiving taxpayer
The Receiving Taxpayer that has used inappropriately transferred NOLs will have the opportunity to voluntarily amend their tax returns, and pay any resulting income tax and late-payment interest and penalties, within 30 business days following the date the name of the identified taxpayer is published in the SAT’s website.
A Receiving Taxpayer that voluntarily amends its tax returns in this manner will have to pay late-payment interest and penalties at an approximate rate of 2.5 percent per month on the unpaid taxes, but will not be subject to additional fines, which can otherwise reach 75 percent of the unpaid income tax.
If the Receiving Taxpayer does not voluntarily amend the applicable tax returns within the 30-day amnesty period, the SAT will very likely initiate audit proceedings. If as a result of the SAT audit, the Receiving Taxpayer is forced to amend returns and pay the resulting income tax, in addition to penalties and interest, it will be required to pay additional fines of 75 percent or more of the unpaid income tax.
NOL generation itself is an issue carefully monitored by the SAT. Article 69-B Bis does not attack the form in which the NOLs are generated but rather, the form in which the NOLs are transferred to another taxpayer. Even if a corporate taxpayer is certain that its NOLs are legitimate, it should examine with the assistance of tax advisors its position if it has been the party to a transaction like those discussed above. If necessary, corporate taxpayers should take preemptive measures to avoid appearing in the SAT’s list of Loss Taxpayers.
Taxpayers that received NOLs after completing one of the above-discussed transactions should monitor the SAT’s list and evaluate whether they are at risk of becoming a Receiving Taxpayer. In addition, taxpayers should consider inserting provisions in their purchase agreements that protect them (such as an escrow requirement) in the event that an NOL proves to be unusable under Article 69-B Bis.
1 In Mexico, all enterprise taxpayers (stock corporations and limited liability companies) are taxed as corporations.
2 In Mexico, by statute, the tax year coincides with the calendar year.
3 All Mexican enterprise taxpayers are required to set-up and maintain a secure, virtual electronic mailbox where all official correspondence to, and with, the SAT is exchanged.