Income Taxes
Current income tax expense represents the amounts expected to be reported on the Company’s income tax returns, and deferred tax expense or benefit represents the change in net deferred tax assets and liabilities. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates that will be in effect when these differences reverse. Valuation allowances are recorded as appropriate to reduce deferred tax assets to the amount considered likely to be realized.
On December 22, 2017, the President of the United States signed into law the Tax Reform Act. The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates, implementing a territorial tax system and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. The Tax Reform Act permanently reduces the U.S. corporate income tax rate from a maximum of 35% to a flat 21% rate, effective January 1, 2018.
The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. As a result of the reduction in the U.S. corporate income tax rate from 35% to 21% under the Tax Reform Act, the Company revalued its ending net deferred tax liabilities at December 31, 2017 and recognized a provisional $487.6 million tax benefit in the Company’s consolidated statement of income for the year ended December 31, 2017.
The Tax Reform Act provided for a one-time deemed mandatory repatriation of post-1986 undistributed foreign subsidiary earnings and profits (“E&P”) through the year ended December 31, 2017. The Company had an estimated $1,479.2 million of undistributed foreign E&P subject to the deemed mandatory repatriation and recognized a provisional $74.6 million of income tax expense in the Company’s consolidated statement of income for the year ended December 31, 2017. After the utilization of existing tax credits, the Company expects to pay additional U.S. federal cash taxes of approximately $44.9 million on the deemed mandatory repatriation, payable over eight years.
While the Tax Reform Act provides for a territorial tax system, beginning in 2018, it includes two new U.S. tax base erosion provisions, the global intangible low-taxed income (“GILTI”) provisions and the base-erosion and anti-abuse tax (“BEAT”) provisions.
The GILTI provisions require the Company to include in its U.S. income tax return foreign subsidiary earnings in excess of an allowable return on the foreign subsidiary’s tangible assets. The Company expects that it will be subject to incremental U.S. tax on GILTI income beginning in 2018, due to expense allocations required by the U.S. foreign tax credit rules. The Company has elected to account for GILTI tax in the period in which it is incurred, and therefore has not provided any deferred tax impacts of GILTI in its consolidated financial statements for the year ended December 31, 2017.
The BEAT provisions in the Tax Reform Act eliminates the deduction of certain base-erosion payments made to related foreign corporations, and impose a minimum tax if greater than regular tax. The Company does not expect it will be subject to this tax and therefore has not included any tax impacts of BEAT in its consolidated financial statements for the year ended December 31, 2017.
On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act. The Company has recognized the provisional tax impacts related to deemed repatriated earnings and the revaluation of deferred tax assets and liabilities and included these amounts in its consolidated financial statements for the year ended December 31, 2017. The ultimate impact may differ from these provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the Tax Reform Act. The accounting is expected to be complete when the 2017 U.S. corporate income tax return is filed in 2018.
Tax Expense (Benefit). Income tax expense (benefit) consists of the following components (in millions):
|
| | | | | | | | | | | |
| 2017 | | 2016 | | 2015 |
Current: | | | | | |
Federal | $ | 47.3 |
| | $ | 1.0 |
| | $ | — |
|
State and local | 0.6 |
| | 0.6 |
| | 0.3 |
|
Foreign | 163.8 |
| | 76.4 |
| | 51.2 |
|
Total current | 211.7 |
| | 78.0 |
| | 51.5 |
|
Deferred: | | | | | |
Federal | (350.1 | ) | | 92.7 |
| | 109.3 |
|
State and local | 11.9 |
| | 13.1 |
| | 15.5 |
|
Foreign | 36.9 |
| | (1.0 | ) | | 11.0 |
|
Total deferred | (301.3 | ) | | 104.8 |
| | 135.8 |
|
Total income tax expense (benefit) | $ | (89.6 | ) | | $ | 182.8 |
| | $ | 187.3 |
|
Income before income taxes consists of the following (in millions):
|
| | | | | | | | | | | |
| 2017 | | 2016 | | 2015 |
Income before income taxes: | | | | | |
U.S. | $ | 331.8 |
| | $ | 279.9 |
| | $ | 315.0 |
|
Foreign | 542.5 |
| | 382.8 |
| | 357.6 |
|
Total income before income taxes | $ | 874.3 |
| | $ | 662.7 |
| | $ | 672.6 |
|
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31 follow (in millions):
|
| | | | | | | |
| 2017 | | 2016 |
Assets: | | | |
Tax credit and loss carryovers | $ | 26.9 |
| | $ | 70.7 |
|
Reserves not currently deductible for tax | 54.1 |
| | 106.4 |
|
Other | 25.2 |
| | 31.6 |
|
Gross deferred tax assets before valuation allowance | 106.2 |
| | 208.7 |
|
Valuation allowance | (2.1 | ) | | (1.7 | ) |
Net deferred tax assets | 104.1 |
| | 207.0 |
|
Liabilities: | | | |
Property | (1,012.7 | ) | | (1,389.0 | ) |
Investments | (48.0 | ) | | (73.8 | ) |
Other | (30.6 | ) | | (33.5 | ) |
Gross deferred tax liabilities | (1,091.3 | ) | | (1,496.3 | ) |
Net deferred tax liability | $ | (987.2 | ) | | $ | (1,289.3 | ) |
Tax Rates. Differences between the Company’s effective income tax rate and the U.S. federal statutory income tax rate of 35% follow (in millions):
|
| | | | | | | | | | | | | | | | | | | | |
| 2017 | | 2016 | | 2015 |
| Dollars | | Percent | | Dollars | | Percent | | Dollars | | Percent |
Income tax expense using the statutory rate in effect | $ | 306.0 |
| | 35.0 | % | | $ | 231.9 |
| | 35.0 | % | | $ | 235.4 |
| | 35.0 | % |
Tax effect of: | | | | | | | | | | | |
Difference between U.S. and foreign tax rate | (25.1 | ) | | (2.9 | %) | | (17.4 | ) | | (2.6 | %) | | (17.8 | ) | | (2.6 | %) |
Foreign exchange (i) | 31.6 |
| | 3.6 | % | | (45.0 | ) | | (6.8 | %) | | (40.5 | ) | | (6.1 | %) |
State and local income tax provision, net | 8.3 |
| | 1.0 | % | | 8.1 |
| | 1.2 | % | | 10.3 |
| | 1.5 | % |
Change in U.S. tax rate | (487.6 | ) | | (55.8 | %) | | — |
| | — |
| | — |
| | — |
|
Deemed mandatory repatriation | 74.6 |
| | 8.6 | % | | — |
| | — |
| | — |
| | — |
|
Other, net | 2.6 |
| | 0.3 | % | | 5.2 |
| | 0.8 | % | | (0.1 | ) | | — |
|
Income tax expense (benefit) | $ | (89.6 | ) | | (10.2 | %) | | $ | 182.8 |
| | 27.6 | % | | $ | 187.3 |
| | 27.8 | % |
_____________________
| |
(i) | Mexican income taxes are paid in Mexican pesos, and as a result, the effective income tax rate reflects fluctuations in the value of the Mexican peso against the U.S. dollar. The foreign exchange impact on income taxes includes the gain or loss from the revaluation of the Company’s net U.S. dollar-denominated monetary liabilities into Mexican pesos which is included in Mexican taxable income under Mexican tax law. As a result, a strengthening of the Mexican peso against the U.S. dollar for the reporting period will generally increase the Mexican cash tax obligation and the effective income tax rate, and a weakening of the Mexican peso against the U.S. dollar for the reporting period will generally decrease the Mexican cash tax obligation and the effective tax rate. To hedge its exposure to this cash tax risk, the Company enters into foreign currency derivative contracts, which are measured at fair value each period and any change in fair value is recognized in foreign exchange gain (loss) within the consolidated statements of income. Refer to Note 9 “Derivative Instruments” for further information. |
Difference Attributable to Foreign Investments. As a result of the deemed mandatory repatriation provisions in the Tax Reform Act, the Company included an estimated $1,479.2 million of undistributed earnings in income subject to U.S. tax at reduced tax rates. The Company does not intend to distribute earnings in a taxable manner, and therefore intends to limit distributions to earnings previously taxed in the U.S., or earnings that would qualify for the 100 percent dividends received deduction provided for in the Tax Reform Act, and earnings that would not result in any significant foreign taxes. As a result, the Company has not recognized a deferred tax liability on its investment in foreign subsidiaries.
Tax Carryovers. The Company has U.S. state net operating losses which are carried forward from 5 to 20 years and are analyzed each year to determine the likelihood of realization. The state loss carryovers arise from both combined and separate tax filings from as early as 1999 and may expire as early as December 31, 2018 and as late as December 31, 2037. The state loss carryover at December 31, 2017, was $426.2 million.
The Mexico federal loss carryovers at December 31, 2017, were $8.4 million and, if not used, will begin to expire in 2026. A deferred tax asset was recognized in prior periods for the expected future tax benefit of these losses which will be carried forward to reduce only Mexican income tax payable in future years.
The valuation allowance for deferred tax assets as of December 31, 2017 and 2016, was $2.1 million and $1.7 million, respectively. The Company believes it is more likely than not that reversals of existing temporary differences that will produce future taxable income and the results of future operations will generate sufficient taxable income to realize the deferred tax assets, net of valuation allowances, related to loss carryovers.
Uncertain Tax Positions. The accounting guidance for uncertainty in income taxes prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The guidance requires the Company to recognize in the consolidated financial statements the benefit of a tax position only if the impact is more likely than not of being sustained on audit based on the technical merits of the position. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in millions):
|
| | | | | | | |
| 2017 | | 2016 |
Balance at January 1, | $ | 3.8 |
| | $ | 1.7 |
|
Additions based on tax positions related to the current year | — |
| | 1.3 |
|
Additions for tax positions of prior years | — |
| | 2.5 |
|
Reductions for tax positions of prior years | (0.1 | ) | | — |
|
Reductions as a result of lapse of statute of limitations | (3.7 | ) | | (1.7 | ) |
Balance at December 31, | $ | — |
| | $ | 3.8 |
|
A tax benefit of $3.7 million was recognized in the third quarter of 2017 relating to a previous uncertain tax position as a result of a lapse of the statute of limitations.
Interest and penalties related to uncertain tax positions are included in income before taxes on the consolidated statements of income. Accrued interest and penalties on unrecognized tax benefits and interest and penalty expense was immaterial to the consolidated financial statements for all periods presented.
Tax Contingencies. Tax returns filed in the U.S. for periods after 2013 and in Mexico for periods after 2011 remain open to examination by the taxing authorities. The Servicio de Administración Tributaria (the “SAT”), the Mexican equivalent of the IRS, completed the examination of the KCSM 2011 Mexico tax return during the third quarter of 2017 without adjustment. An SAT examination was completed during the second quarter of 2017 without adjustment for the KCSM Servicios 2013 Mexico tax return. The Company received audit assessments from the SAT during the first quarter of 2017 for the KCSM 2009 and 2010 Mexico tax returns. The Company commenced administrative actions with the SAT and if these assessments are not nullified, the matters will be litigated. The Company believes that it has strong legal arguments in its favor and it is more likely than not that the Company will prevail in any challenge of the assessments.
The Company litigated a Value Added Tax (“VAT”) audit assessment from the SAT for KCSM for the year ended December 31, 2005. In November 2016, KCSM was notified of a resolution by the Mexican tax court annulling this assessment. The SAT appealed this resolution to the Mexican circuit court. In September 2017, KCSM was notified of a resolution by the circuit court which ordered the tax court to consider an argument made by KCSM in the original tax court proceeding that was not addressed in the tax court’s November 2016 resolution. In October 2017, the tax court ruled that the arguments made by KCSM asserting that the SAT unduly extended the audit process were not valid, and also annulled the assessment consistent with the tax courts earlier November 2016 ruling. In December 2017, KCSM and the SAT filed an appeal with the Federal Courts of Appeals. The Company believes it is probable that the court will continue to annul the 2005 VAT assessment. Further, the Company believes it is more likely than not that the SAT will ultimately be precluded from issuing a new 2005 VAT audit assessment. In the unexpected event that the SAT is provided the opportunity to issue a new 2005 VAT audit assessment, the Company cannot predict if the SAT would issue a new assessment or the basis of any new assessment. Accordingly, the Company is not able to estimate any related potential exposure.
KCSM has not historically assessed VAT on international import transportation services provided to its customers based on a written ruling that KCSM obtained from the SAT in 2008 stating that such services were not subject to VAT (the “2008 Ruling”). Notwithstanding the 2008 Ruling, in December 2013, the SAT unofficially informed KCSM of an intended implementation of new criteria effective as of January 1, 2014, pursuant to which VAT would be assessed on all international import transportation services on the portion of the services provided within Mexico. Additionally, in November 2013, the SAT filed an action to nullify the 2008 Ruling, potentially exposing the application of the new criteria to open tax years. In February 2014, KCSM filed an action opposing the SAT’s nullification action. In December 2016, KCSM was notified of a resolution issued by the Mexican tax court confirming the 2008 Ruling. The SAT appealed this resolution. In October 2017, the Circuit Court resolved to not render a decision on the case but rather to send the SAT’s appeal to the Supreme Court. The Supreme Court will decide whether it will hear the case and render a decision, or remand the SAT’s appeal back to the Circuit Court for a decision. The Company believes it is more likely than not that it will continue to prevail in this matter. Further, as of the date of this filing, the SAT has not implemented any new criteria regarding this assessment of VAT on international import transportation services. The Company believes it is probable that any unexpected nullification of the 2008 Ruling and the implementation of any new VAT criteria would be applied on a prospective basis, in which case, due to the pass-through nature of VAT, KCSM would begin to assess its customers for VAT on international import transportation services, resulting in no material impact to the Company’s consolidated financial statements.