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.

Tax Expense. Income tax expense consists of the following components (in millions):



	2014			2013		2012
Current:
Federal	$	(2.5	)	$	6.0	$	2.8
State and local	1.2			1.9		0.7
Foreign	70.0			79.2		36.2
Total current	68.7			87.1		39.7
Deferred:
Federal	112.6			99.0		99.2
State and local	16.9			11.9		(7.4		)
Foreign	10.6			0.3		105.5
Total deferred	140.1			111.2		197.3
Total income tax expense	$	208.8		$	198.3	$	237.0

Income before income taxes consists of the following (in millions):



	2014		2013		2012
Income before income taxes:
U.S.	$	341.8	$	319.2	$	282.8
Foreign	371.3		232.4		333.6
Total income before income taxes	$	713.1	$	551.6	$	616.4

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities follow at December 31 (in millions):



	2014			2013
Assets:
Loss carryovers	$	52.2		$	52.6
Reserves not currently deductible for tax	94.5			91.2
Other	69.3			64.6
Gross deferred tax assets before valuation allowance	216.0			208.4
Valuation allowance	(0.9		)	(2.7		)
Net deferred tax assets	215.1			205.7
Liabilities:
Property	(1,194.7		)	(1,044.6		)
Investments	(68.2		)	(66.3		)
Other	(8.4		)	(7.8		)
Gross deferred tax liabilities	(1,271.3		)	(1,118.7		)
Net deferred tax liability	$	(1,056.2	)	$	(913.0	)

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):



	2014					2013					2012
	Dollars			Percent		Dollars			Percent		Dollars			Percent
Income tax expense using the statutory rate in effect	$	249.6		35.0	%	$	193.1		35.0	%	$	215.7		35.0	%
Tax effect of:
Difference between U.S. and foreign tax rate	(23.0		)	(3.2	%)	(15.4		)	(2.8	%)	(18.4		)	(3.0	%)
Foreign exchange and inflation adjustments (i)	(25.6		)	(3.6	%)	4.7			0.8	%	42.3			6.9	%
State and local income tax provision, net	11.7			1.6	%	8.9			1.6	%	8.4			1.3	%
Change in valuation allowances	(1.8		)	(0.3	%)	(0.9		)	(0.2	%)	(11.2		)	(1.8	%)
Other, net	(2.1		)	(0.2	%)	7.9			1.5	%	0.2			—
Income tax expense	$	208.8		29.3	%	$	198.3		35.9	%	$	237.0		38.4	%

_____________________

(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. Most significantly, any gain or loss from the revaluation of net U.S. dollar-denominated monetary liabilities (primarily debt) into Mexican pesos 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 risk, during 2014 and 2013 the Company entered into foreign currency forward 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 8 Derivative Instruments for further information.

Difference Attributable to Foreign Investments. At December 31, 2014, the Company’s book basis exceeded the tax basis of its foreign investments by $1,593.9 million. The Company has not provided a deferred income tax liability for the income taxes, if any, which might become payable on the realization of this basis difference because the Company intends to indefinitely reinvest in foreign investments the operating earnings which gave rise to the basis differential or remit the earnings in tax-free transactions. Moreover, the Company has no other plans to realize this basis differential by a sale of its interests in foreign investments. If the earnings were to be remitted in a taxable transaction, as of December 31, 2014, the Company would incur gross federal income taxes of $557.9 million which would be partially offset by foreign tax credits.

Changes in Tax Law. On December 11, 2013, changes to the Mexican Federal Income Tax Law were approved eliminating the statutory income tax rate reduction to 29% for 2014 and 28% for 2015 and thereafter, and leaving the existing 30% statutory income tax rate in effect for future years. Additionally, the Entrepreneurial Tax of Unique Rate (referred to by its Spanish acronym, IETU or Flat Tax) was repealed as of January 1, 2014. The Company's deferred income tax assets and liabilities as of December 31, 2013 were revalued using the rates expected to be in effect when the underlying temporary differences are expected to reverse. The change in tax law did not have a material impact to the consolidated financial statements.

Tax Carryovers. The Company has both U.S. federal and state net operating losses which are carried forward 20 years for federal tax purposes and from 5 to 20 years for state tax purposes. Both the federal and state loss carryovers are analyzed each year to determine the likelihood of realization. The U.S. federal loss carryover at December 31, 2014, was $32.8 million and if not used, would begin to expire in 2023. The consolidated financial statements do not reflect $8.9 million of federal loss carryovers due to a limitation on recognized excess tax benefits related to share based compensation until they are used to reduce current taxes payable at which point will be recognized as an increase to additional paid in capital. In addition, the Company has $37.3 million of tax credit carryovers consisting primarily of $31.7 million of track maintenance credits which, if not used, will begin to expire in 2024.

The state loss carryovers arise from both combined and separate tax filings from as early as 1999. The loss carryovers may expire as early as December 31, 2015 and as late as December 31, 2034. The state loss carryover at December 31, 2014, was $472.5 million.

The Mexico federal loss carryovers at December 31, 2014, were $83.5 million and, if not used, will begin to expire in 2019. A deferred tax asset was recorded 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. A deferred tax asset is also recorded for an asset tax credit carryover in the amount of $5.7 million, which, if not used, will begin to expire in 2017.

The valuation allowance for deferred tax assets as of December 31, 2014 and 2013, was $0.9 million and $2.7 million, respectively.

The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets, net of valuation allowances, related to loss carryovers and tax credits.

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):



	2014			2013
Balance at January 1,	$	3.5		$	3.6
Additions based on tax positions related to the current year	—			—
Additions for tax positions of prior years	—			—
Reductions for tax positions of prior years	(1.8		)	(0.1		)
Balance at December 31,	$	1.7		$	3.5

All of the unrecognized tax benefits would affect the effective income tax rate if recognized and is not expected to significantly change in the next twelve months.

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 2010 and in Mexico for periods after 2008 remain open to examination by the taxing authorities. In 2014, the Internal Revenue Service (“IRS”) initiated an examination on the 2011 and 2012 U.S. federal tax returns. This examination was completed and settled in the fourth quarter of 2014 with an immaterial impact to the consolidated financial statements. The Servicio de Administración Tributaria (the “SAT”), the Mexican equivalent of the IRS, is currently examining the KCSM 2009 and 2010 tax returns and the KCSM Servicios 2012 tax return. In the fourth quarter of 2014, the 2007 KCSM examination was completed without adjustment. The Company is litigating a Value Added Tax (“VAT”) audit assessment from the SAT for KCSM for the year ended December 31, 2005. The Company believes it is more likely than not that it will prevail in challenging the KCSM 2005 assessment. While the outcome of this matter cannot be predicted with certainty, the Company does not believe, when resolved, that this dispute will have a material effect on its consolidated financial statements. However, an unexpected adverse resolution could have a material effect on the consolidated financial statements in a particular quarter or fiscal year.

NAFTA Rail, S. de R.L. de C.V. (NAFTA), a wholly-owned subsidiary of KCS, recorded a receivable from the SAT for VAT paid by NAFTA in connection with NAFTA’s purchase of locomotives. NAFTA subsequently collected VAT in connection with leasing these locomotives, and offset the resulting VAT payable against the existing VAT receivable. The SAT issued a resolution in 2013 which denied this offset, and assessed payment. NAFTA litigated this resolution and in January 2015 a Mexican tax court issued a favorable ruling by dismissing the SAT resolution. The SAT has the right to appeal this tax court decision. An adverse resolution could result in the determination that approximately $13.4 million of VAT receivable recorded by NAFTA is not recoverable.

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 exempt from 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. While the SAT’s unofficial communication to KCSM is not enforceable and the 2008 Ruling continues to be in effect, KCSM notified its customers in December 2013 of the potential assessment of VAT on international import transportation services; however, implementation of any VAT assessment will depend on future developments and any guidance published by the SAT. Due to the pass-through nature of VAT assessed on services provided to customers, the Company does not believe any ultimate requirement to assess VAT on international import transportation services will have a significant effect on its consolidated financial statements. However, unexpected adverse implementation criteria imposed by the SAT for open tax years could have a material effect on the consolidated financial statements of the Company in a particular quarter or fiscal year.