Mexico: The relevance of the social security due diligence
The social security system of any country must be analysed for taking the best decisions in M&A transactions. Yazmin Caceres and María Dolores Enríquez Medina of PwC explain why this analysis should take into account the legislation, practices and risks that investors may face in Mexico.
Mexico has a particular social security system that taxpayers should be aware of to achieve successful transactions, by recognising past tax risk and future challenges. Mexico is an attractive location for investors. The stability of its economy and the reliability of its growth supported by the recently enacted structural energy reforms (oil and energy) and in the areas of telecommunications, tax, finance and labour, open up new and interesting business opportunities that many investors are eager to take advantage of.
As part of this wave of confidence, there are certainly companies with clear intentions of growth involving acquisitions in Mexico. What's more, there must be investors that have already pinpointed opportunities and are getting ready to carry out a due diligence of the basic areas that will allow them to confirm the profitability and expectations of growing of the business while determining guarantees for their investment, for example, financial, operational, commercial, legal, environmental, taxes and human resources.
We would like to call your attention to an area of critical importance, particularly if your investment is to be made in Mexico: The social security due diligence.
For years, one of the principal Social Security issues in Mexico has been the inability of the Mexican Social Security Institute (the IMSS – the government agency supplying and managing social security in Mexico) to adequately cover Mexican employees' health needs. The demand for services has far outpaced the IMSS capacity to provide them, and pension payments are handled through a system that is facing serious financial problems.
IMSS resources, to certain extent, arise from the social security contributions incurred by both the employer and the employee (through withholding made by the employer) filed with the social security authorities. Contributions are calculated as a percentage of each employee's wages, and the computation differs depending on work risk, among other items. Those dues are classified as per the different insurance branches: illness and maternity, occupational risk, invalidity and life, retirement, day nurseries and other benefits. It is important to mention that social security provisions, which involve laws, regulations, criteria and agreements, are often complex and require special know-how for proper interpretation and compliance.
However, over the years, employers and employees have implemented tax strategies to reduce social security dues. The labour authorities have been aware of the problem, and amendments have been made to different laws and have been issued new criteria to bring those practices to a halt.
Stock deal versus asset deal: A social security issue
A party acquiring shares assumes responsibility for all tax and labour contingencies (including social security), which is why parties acquiring a business generally prefer to acquire assets with a view to limiting or eliminating, to the extent possible, responsibility for tax risks arising from aggressive tax practices or criteria implemented by the outgoing management.
The foregoing is not fully applicable for social security purposes. If an asset deal is carried out, and the employees are transferred to the new company under a so-called "employer replacement", the former employer (the seller) is jointly liable for the obligations of the new employer (the buyer) for the six months following the replacement. After that term elapses, the only party responsible for any obligation arising from the social security law is the new employer, even when those liabilities arise from years before the acquisition.
The employer replacement arrangement involves certain requirements: There must be a transfer of essential goods from one employer to another for continued exploitation and the two companies must be engaged in the same line of business.
There are also other consequences for the new employer; for example, the percentage for work risk premiums continues to be the same, which could be above or below those payable by a newly created company. It is therefore important to evaluate those costs. Additionally, the employer registration (the registration number used by the IMSS to control registered members) remains the same.
However, there are cases in which we are not in the presence of an employer replacement, such as when only some of the employees are transferred from one company to another (because the others might be engaged in different lines of business not subject to the transaction). In that case, the social security authorities must merely be notified, and the employees in question must be registered as employed by the new company. In that case, although there is an employer replacement for labour purposes (the new employer inherits all obligations involving the transferred employees, principally concerning seniority), for social security purposes, the new employer is not held responsible for contingencies arising from past years.
The new company acquires a new employer registration and is assigned the median work risk premium for the operations in which the company is engaged, which could be above or below what the previous company was paying. The work risk premium percentage is from 0.5% to 15%.
Social security due diligence
Among Mexican companies, it is usual to have structures which include an operating company and a service company (which may or not be a related company) holding the employees rendering services to the operating company (outsourcing).
In principle, the point of separating the employees from the operating company is to control employees' statutory profit-sharing (PTU). Although PTU is not a tax, every Mexican business with employees is required to distribute a portion of its annual profits among its employees, except directors and the general manager. The amount of profit to be distributed is equal to 10% of the business's taxable income, with certain modifications. No profit sharing is paid during the first year of operations.
Outsourcing makes it possible to control PTU, as profits subject to distribution arise directly from the profits of the service company, which is limited to the markup applied to the services rendered to the operating company (complying with the arm's-length principle in the case of related parties) or to the subcontractor's profit on services rendered.
There have also been cases in which this structure has led to noncompliance with labour, tax and social security obligations. For example:
a) The transfer of employees to cooperative entities (Sociedad Cooperativa). In Sociedad Cooperativa the salaries are paid as an advance on performance, and welfare benefits, which are not taxed for income tax purposes. The social security dues are calculated considering this minimum wage so the corresponding dues are minimised too.
b) The transfer of employees to civil entities (Sociedades Civiles): In Sociedades Civiles the employees are considered to be partners of the company, so the salaries are paid as advances against future profits, which according to the Mexican Laws are not subject to social security dues.
c) The transfer of employees to unions, universal entities, etcetera, which apply the benefits included in the social security provisions to pay minimum dues.
d) Salaries paid by segment, through two or more companies, with no business purpose.
e) The use of alternate arrangements:
Payments qualifying as salaries
Payments to individuals engaged in business activities
To stop these practices, the Mexican Government and tax authorities have amended labour and tax provisions and have issued criteria regulating the requirements for the payment of dues. For example, there is currently a criterion establishing that it is considered an unacceptable tax practice:
To incorporate a Sociedad Cooperativa or directly or indirectly contracting a Sociedad Cooperativa to render services that are identical, similar or analogous to the services presently or previously rendered by a company's own employees or service providers.
A Sociedad Cooperativa that deducts amounts delivered to its cooperative partners from the Welfare Fund, or any cooperative partner that fails to consider those amounts as income subject to income tax.
Any party that provides advisory or other services in connection with, or participates in the realisation or implementation of, any of the above practices.
In such cases, the authorities could demand payment of dues plus adjustment for inflation, interest and applicable fines.
Note that until 2013, as a means of facilitating the official review of corporate tax compliance, the Mexican Federal Tax Code contains a procedure that requires most business enterprises (which comply with certain provisions) to file financial statements together with the special tax statutory report issued by an independent public accountant registered with the tax authorities. Through this statutory report the independent public accountant has the obligation to disclose the existence of any unacceptable tax practice.
Other arrangements that are also subject to considerable scrutiny are those allowing the payment of fees to employees for personal subordinated services or under the regime for fees qualifying as salaries, where the persons rendering services are not considered to be company employees but service providers, whose compensation is not subject to social security dues.
In that regard, the social security authorities consider that if the service is rendered on a continuous basis and represents the individual's principal income, that individual is subject to social security registration.
Other cases include off-payroll payments in cash not entered into the accounting records.
Note that the new Federal Labour Law issued in late 2012 substantially modified provisions pertaining to outsourcing (the previous social security law had included certain articles of that nature) whereby service companies and the companies contracting them are held jointly liable for compliance with labour obligations to the employees. It should be noted that the obligation pertains to all labour obligations, not only to the payment of social security dues, in the event that the employer has failed to comply with them.
The amendments to the Federal Labour Law do not allow subcontracting when employees are deliberately transferred from the contracting company to the subcontractor for the purpose of reducing labour rights.
Those amendments also require companies contracting services to ensure that the service company complies with all its labour obligations. The social security law also establishes obligations for individuals or entities signing agreements with service providers so as to ensure the payment of dues.
As can be seen, there are different employee payment arrangements that could affect the business profitability, which make prompt detection and correct quantification is critical in any due diligence review, as the effects could impact business results when a company comes under new management and those practices are halted.
As a result, it could be important to take the following suggestions for a social security due diligence process with a Mexican target: i) the verification of payment and reasonability of social security and workers' housing fund dues, ii) analysis of the social security compliance reports (if applicable), iii) evaluate potential social security exposures resulting from classification of employees as independent contractors, commissioners, professional fees, versus employees, iv) analyse the classification of companies as compared to its business activity for purposes of the work risk premium, v) analysis of labour union contracts and vi) verification of outsourcing schemes.
Note that social security risks must be calculated for five years (the statute of limitations for official reviews), considering the worst case scenario, which aside from social security dues, includes adjustment for inflation, interest and penalties (for social security purposes the penalties could be up to 100% of restated dues).
It is also important to value any joint liability with the company providing the personnel services, as well as compliance with the respective labour obligations.
Structuring the transaction
There are certain ways of minimising the risks arising from aggressive approaches, such as the selling entity laying off its employees as per the provisions of the Federal Labour Law and the new employer contracting them with new benefits, which not only eliminates any risks arising from past actions, but could be very onerous as it concerns employee seniority.
Another way of minimising the risk is contracting only certain employees so that no employer replacement is considered to take place for social security purposes. Naturally, these matters must be evaluated on a case-by-case basis.
Mexico will continue to be a preferred destination for investors for many years to come, buoyed by the growth promised by its structural reforms.
Given its importance, social security matters should be considered as one of the areas requiring review. A social security due diligence that makes it possible to determine the risks incurred by the seller over the most recent five years, risk evaluation, proper structuring of the transaction and establishing guarantees in the respective contracts, will allow for a successful transaction concerning employees in Mexico.
Mariano Escobedo 573
Col Rincón del Bosque, 11580
Tel: +52 55 5263 6148
Fax: +52 55 52 63 6010
Yazmin is a mergers and acquisitions (M&A) tax partner for the Mexico City office of PwC. Yazmin has worked for over 15 years as an M&A professional. She has broad experience in due diligence engagements and has provided tax advisory services that include identifying, analysing and quantifying risks, advisory for tax planning and streamlining, planning transactions and assistance for the closing of transactions.
Core expertise areas: (i) tax due diligence, (ii) tax efficient structuring, (iii) address due diligence issues and opportunities, (iv) review of tax compliance including estimated payments and annual filings, (v) advise on transfer pricing requirements, (vi) tax audits, (vii) communication with Mexican tax authorities, (viii) ensure correct reporting of tax teams involved in the due diligence process (social security, custom duties, labor, transfer pricing).
Yazmin is a certified public accountant and coauthor of the book "Fusiones y Adquisiciones en México: Teoría y Práctica Gerencial", in collaboration with the Instituto Tecnológico Autónomo de México (ITAM) and Instituto Mexicano de Ejecutivos en Finanzas (IMEF).
María Dolores Enríquez Medina
Mariano Escobedo 573
Col Rincón del Bosque
CP 11580 México DF
Tel: +52 55 5263 85 90
Mobile: +52 1 55 27550490
Fax: +52 55 5263 6010
Dolores is a tax senior manager specialised in social security affairs for the Mexico City Office. She has 31 years of professional experience, 20 of them in the audit practice performing financial statements audits for clients, and 11 years fully dedicated to social security aspects including specific advice for labour and M&A transactions.
Dolores generally performs social security evaluations to assess tax contingencies derived from the way in which the social security dues are paid by the companies and makes recommendations to reduce tax risks. Her day-to-day main activities consist of advising clients in social security planning and providing support to be in compliance with the provisions set forth in the respective labour and social security laws.
Dolores is a certified public accountant from La Salle University
Dolores is member of the College of Public Accountants of Mexico, in which she is part of the Representative Committee to Social Security Organisms.