New complex reorganisation rules in Colombia’s vibrant M&A market

January 2014 | EXPERT BRIEFING | MERGERS & ACQUISITIONS

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The last decade has been a remarkably vibrant economic period for Colombia. Many local assets and companies have gone to foreign investors and M&A activity in the country continues to rise.

In a recent tax reform, lawmakers introduced to the Colombian tax free reorganisations regime, a series of novel restrictions in an effort to prevent the use of tax free reorganisations as vehicles to divest from local assets and companies without paying a fair share of tax in Colombia, thereby closing the former regime that was too lenient and generous.

In this article we aim to raise awareness among the foreign investors community interested in Colombia, about the complexities they will now face when considering an M&A transaction with Colombian parties, and about the importance of seeking sophisticated local tax counsel in advance.

Introduction

Foreign investment within Colombia doubled between 2008 and 2012, according to the Colombian Central Bank 2012 report (February 2013), and cross-border mergers and takeovers have reached record levels in the past two years.

In 2011, Colombia ranked as the second country in Latin America for the greatest amount of share issues in the stock market, surpassing Mexico for the first time, according to the Colombian Stock Exchange (BVC) 2011 report, based on Mergermarket’s figures of June 2011 and WFE’s figures for 2011.

In light of the above, Colombia’s government undertook wide-ranging reforms to address structural weaknesses and improve competitiveness, one of which was the Tax Reform Act No. 1607, enacted on December 2012 (the ‘2012 TRA’).

Through this recent Tax Reform Act, lawmakers placed greater emphasis on improving tax rules to be more in line with OECD guidelines. Also, the Colombian government aimed to prevent abuse in M&A transactions, in order to increase tax collections in an apparently thriving economic environment. Unfortunately, the 2012 TRA introduced a set of confusing rules regarding reorganisations, confronting parties with the need to undertake deeper and more sophisticated analysis when structuring M&A transactions.

Tax free reorganisations redefined

Before the 2012 TRA the statutes lacked clarity regarding the treatment of non-cash property transfers to corporations as capital contributions, while offering an unrestricted tax free treatment to all statutory mergers and spin offs. The 2012 tax reform establishes a reorganisations chapter with specific anti-avoidance rules to address these issues, in an effort to curtail M&A transfer strategies that resulted in acquisitions of corporate assets and businesses in Colombia which, due to current loopholes in the statutes, avoided local taxation.

Until 31 December 2012, Colombia had a lenient tax free reorganisations regime, under which virtually any merger or spin off fulfilling the corresponding corporate law requirements was immediately afforded tax free treatment. The new regime, in place as of 1 January 2013, makes M&A transactions far more complex from a tax standpoint, requiring the involvement of tax advisers with experience and skills to help investors navigate the new rules.

Tax free capital contributions of property

Before the 2012 tax reform, only capital contributions in cash were income tax neutral while property contributions could potentially be subject to taxation upon transfer to a corporation. Due to the lack of regulation, before 2013 the Colombian Tax Service dealt with this situation through a series of cumbersome revenue rulings that the taxpayer had to navigate in order to mitigate unreasonable taxation. The new provisions intend to adopt clear rules regulating taxable and tax free capital contributions of property.

According to the new applicable rules, unless otherwise provided by the statute, property transfers to corporations, implemented as capital contributions, will be deemed tax free. Therefore, the stock received by the transferor will inherit the tax basis in the transferred property, while the transferee corporation keeps the same tax basis in the property that the transferor had.

In other words, when expressly and voluntarily electing this alternative, under the new tax rules equity contributions will be treated as a tax free event, neutral from a tax standpoint. There is neither taxable income nor an alienation of assets between the parties involved.

All capital contributions of property, including stock, where the transferor is a Colombian national individual or entity and the transferee corporation is an offshore entity, under the proposed statute: (i) will be deemed as taxable without exception; and (ii) must observe transfer pricing rules, regardless of the existence of a ‘related-party’ relationship between transferor and transferee and regardless of the value attributed to the contributed property.

Tax free statutory mergers and spin offs restricted

In an effort to prevent the use of statutory mergers and spin offs as a means of achieving tax free status for certain acquisitions of corporate assets and businesses in Colombia, the 2012 TRA introduced statutory requirements for these types of reorganisations to qualify for tax free treatment. Already existent, joint and several liability for taxes between the participating entities in reorganisations is being restated along with the newly proposed rules.

In order to achieve tax free treatment, the applicable rules provide for a tax cost rollover concerning both the transferred assets and the new shares issued to the shareholders.

These requirements are somewhat similar to those in other jurisdictions, and are based on a continuity of interest (COI) and on continuity of business enterprise (COBE), in the absence of which the reorganisation will not qualify for tax free treatment.

In addition to the adoption of COI and COBE requirements, the new statute differentiates ‘acquisition’ mergers and spin offs, as opposed to ‘organisational’ mergers and spin offs.

For acquisition reorganisations, the participating entities must not be deemed as related parties under Colombian regulations, while for organisational mergers, the participating entities must be deemed as related parties under Colombian regulations. The difference between these two tax types of reorganisation results in the adoption of stricter COI and COBE requirements for organisational mergers and spin offs.

The newly adopted statutory requirements vary depending on whether the taxpayer enters into an acquisition or an organisational reorganisation.

In acquisition mergers and spin offs, no transfer of shares is deemed to take place for the shareholders of the companies involved, to the extent that certain conditions are met, such as: (i) the owners of 75 percent of the sharesof the existing companies have to participate in the resulting company or companies; and (ii) the shareholders must receive an equivalent participation representing no less than 90 percent of the resulting capital.

The requirements that apply to acquisition mergers or spin offs also apply to organisational mergers and spin offs, except certain thresholds increase. Specifically: (i) the owners of 85 percent of the shares of the existing company have to participate in the resulting company or companies; and (ii) the shareholders must receive a materially equivalent participation representing no less than 99 percent of the resulting capital.

Also, the new tax law states that for foreign and domestic companies participating in a merger or spinoff, no taxable event would be deemed to the extent that the absorbing company (in mergers) or the resulting company (in spin offs) is a domestic entity.

If all the these requirements are met, a spin off or merger can be treated as a tax free reorganisation for Colombian tax purposes. Otherwise, the operation will be taxed either as ordinary income (34 percent) or as a capital gain (10 percent), depending on whether the transferred assets are fixed assets held for more than two years.

Also, for those mergers and spin offs subjected to tax free treatment, a two year minimum holding period is required,otherwise a special fine may be imposed. The tax law establishes a lock-up rule in the case of the sale of shares in entities that have participated in a merger or spin off. According to this rule, shareholders must keep their shares in the entities participating in the merger for at least two years or they will have to pay the higher of the following two amounts: (i) the corresponding income tax liability (i.e., 33 percent or 10 percent of the capital gain depending on whether the shares have been held for less or more than two years respectively) plus an additional 30 percent applicable to the income tax liability; or 10 percent of the value of the shares.

Offshore reorganisations entailing Colombian assets

In reorganisations between foreign entities entailing the transfer of assets located in Colombia, the transfer of the Colombian assets will be deemed as taxable and will not be eligible for tax free treatment. In this case, if the Colombian assets transferred as a result of the reorganisation represent 20 percent or less of the worldwide combined assets of the economic group, the resulting transfer of the Colombian assets could be eligible for tax free treatment observing the COI and COBE requirements and related rules as discussed above.

Conclusion

Although confusing and abundant in complexity, the new tax rules are clearly geared towards avoiding: (i) the shareholders of the companies involved receiving a different participation percentage as a consequence of the merger or spin off; and (ii) the shareholders of the companies involved receiving a different kind of compensation as a consequence of the merger or spin off, rather than shares in the merged or spun off entity.

Despite the Colombian government’s effort, the complex wording of the 2012 TRA section on reorganisations and the lack of clarity in these new rules has created an environment of legal uncertainty for foreign investors and their Colombian counterparties, and has created the need for more complex and sophisticated analysis when implementing an M&A transaction in Colombia. This dramatically increasing the expenses that foreign investors and Colombian counterparties have to incur in legal and tax advice when structuring an M&A transaction in Colombia.

Nonetheless, in an increasingly vibrant M&A environment which, for the time being, continues to be apparently moving forward, these new complex reorganisation rules should be considered an issue to deal with appropriately and in advance.

Adrian Rodriguez is a partner and Ana Correa is an associate at Lewin & Wills. Mr Rodriguez can be contacted by email: arodriguez@lewinywills.com. Ms Correa can be contacted by email: acorrea@lewinywills.com.

Adrian Rodriguez and Ana Correa

Lewin & Wills