Ernst & Young, Argentina: Legal Certainties in Argentina – Court Sides with Business
Sergio Caveggia and Leonardo Favaretto of EY explain the implications of the Spinna Argentina SRL case with regard to Income Tax Law and Argentine Business Associations Law and what current regulations say in these cases.
Recently, the Federal Court of Appeals on Contentious Administrative Matters in and for the City of Buenos Aires (the Court of Appeals) handed down a ruling in the Spinna Argentina SRL case, shedding light on the tax treatment of capital reductions.
Specifically, the case involves a corporate reorganization process and compliance with certain specific requirements set forth in Income Tax Law in a mandatory capital reduction process. For some background, Spinna Mortero Argentina SRL merged with and into Spinna Argentina SRL in a tax-free merger process.
According to the Court of Appeals ruling, the successor company (Spinna Argentina SRL) was required, after the reorganization, to reduce its capital on two occasions pursuant to section 206, Argentine Business Associations Law. These reductions were made within the two-year period following the reorganization date.
“In general, Income Tax Law favors application of the accrual method, for recognizing both income and associated expenses.”
The AFIP (Federal Public Revenue Agency) decided not to accept the corporate reorganization, arguing that the surviving company had failed to meet the requirement of maintaining the equity interest for a period of at least two years since the reorganization date.
To bring greater clarity to the issue at hand, we will briefly describe the tax regulations governing this treatment and the requirements that need to be fulfilled in order for a business reorganization to be considered a tax-free process.
Section 77, Income Tax Law provides for a special system applicable to certain reorganizations carried out between companies, and basically provides for three types of reorganizations:
- Sales and transfers between companies belonging to the same group.
Certain tax rights and obligations are transferable to the surviving company or companies in the cases of such reorganizations.
Income Tax Law sets forth that the income which may arise as a consequence of a reorganization will not be subject to income tax as long as the following requirements are complied with:
- The surviving entity must continue with the same or a related activity as the predecessor companies for at least two years from the date of reorganization.
- The reorganization must be reported to the tax authorities within 180 days of it taking place.
- An equity interest (80% as mentioned above in the case of mergers) in the capital of the surviving company not lower than the equity interest held upon reorganization, as in the capital requirement, must be maintained for at least two years as from the time of the reorganization (in the case of listed companies this requirement would not apply provided that the company continues to be listed for at least two years. This requirement is also known as the future two-year ownership rule.
An additional requirement applies for transferring NOLs (Net Operating Losses) and benefits from special promotion systems:
- The transfer of net operating losses from the predecessor company is limited to the extent that its shareholders can prove that, during the two years prior to the reorganization date, they maintained at least 80% of their interest in such entity. This requirement is also known as the prior two-year ownership rule.
This requirement is not applicable to the transfer of VAT credits, which are transferable only by complying with the rest of the tax-free system requirements. In other words, VAT credits are transferable under a tax-free reorganization regardless of actual compliance with the prior two-year ownership rule.
Additional requirements apply for mergers and spin-offs:
- The merging companies must be active, i.e., they must be operating in furtherance of their corporate purpose.
- Both companies should have carried out the same or related activities for at least 12 months as of the reorganization date.
- The companies should continue to engage in one of the activities of the reorganized company or companies or of the other companies related to them for at least two years.
The Case at Hand
We mentioned that section 77(8), Income Tax Law sets forth as follows: “For the reorganization of companies to have the tax effects established in this section [being tax-free], for at least two (2) years as from the reorganization date, the owners of the predecessor companies shall hold an equity interest not lower than the one that they should have held in the surviving company’s equity as of such date, as provided for in each case by the regulations.”
The law’s administrative order confirms what is stated by the abovementioned section, asserting that what should remain the same is the equity interest amount and, therefore, not the actual percentage per se.
Lastly, section 206, Argentine Business Associations Law provides that “the reduction [in reference to the capital reduction] is mandatory when losses consume reserves and 50% of the capital stock”.
Now we get to the focal point of this discussion. In effect, the Court of Appeals analyzed whether the mandatory capital reduction established by the abovementioned regulations can be considered a breach of the requirement to maintain the equity interest amount under Income Tax Law.
In other words, if a law requires a company to reduce its capital stock because of a going concern issue to balance or even out its equity, can compliance of this cause the loss of benefits (in this case, tax benefits) granted by another law?
In any case, can a taxpayer facing this dilemma choose what law to abide by or, in other words, choose which the lesser evil is and act accordingly?
AFIP challenged the tax benefit used by the taxpayer, arguing that the mandatory capital reduction caused the company to fail to meet the requirement of maintaining the equity interest amount during the two-year term following the reorganization date.
The Court of Appeals did not accept the arguments provided by AFIP and, therefore, dispensed with the tax requirement of maintaining the equity interest, ordering the losing party to bear legal costs.
It cited section 1,071 of the Civil Code which establishes that “when a person exercises one of their rights or complies with a legal obligation in a normal manner, no such act can be deemed to constitute an illegal act.” The opposite would mean placing the company in the false dilemma of whether to comply with one regulation or another.
Precisely, Argentine Supreme Court of Justice jurisprudence contends that we should not assume that legislators are inconsistent and, accordingly, laws are to be interpreted in such a manner so as to avoid attributing a meaning to them that will make their provisions come into conflict with each other; rather, the meaning to be attributed should reconcile them to each other and ensure that all remain in full force and effect.
We can only agree with the arguments of the Courts and, through this column, stress the fact that rulings such as these give economic players legal certainty.
About the Authors
Sergio Caveggia (Partner) and Leonardo Favaretto (Senior Manager) are members of Ernst & Young’s Transaction Tax Department.