Tax bullying? When global tax trends clash with local realities
Rafael Sayagues, Isabel Chiri and Alexandre Barbellion of EY look at the role of Central American countries Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua and Panama in the global tax playground and whether a cascading ‘tax bullying’ effect can be seen when global trends are established
The OECD is on track to finalise its extremely ambitious and controversial Base Erosion and Profit Shifting (BEPS) Action Plan this year. The final package of the 15 action items is expected in October.
The G20 finance ministers and central bank governors said in the closing communiqué of their last meeting held in Turkey on September 4 and 5, 2015: "We call on the OECD to prepare a framework by early 2016 with the involvement of interested non-G20 countries and jurisdictions, particularly developing economies, on an equal footing. We welcome the efforts by the IMF, WBG [World Bank Group], UN and OECD to provide appropriate technical assistance to interested developing economies in tackling the domestic resource mobilization challenges they face, including from BEPS. We continue to work to enhance the transparency of our tax systems (…)."
This statement reflects the reality that if certain OECD members and other large economies will have issues implementing the proposed changes, certain developing economies will definitely not be ready to implement BEPS recommendations. We certainly view this as being the case for Central America and, several of the initiatives should not even be a priority for countries in this region in the first place.
The influence of global tax trends in Central America that we have observed in the recent past will continue to grow; it is an inevitable process that stems from the overall globalisation of economies in an increasingly borderless world. Who would have thought just a couple of years ago that even a Central American country – Costa Rica – would be in the process of becoming an OECD member? It is a process that calls for extreme cautiousness. There cannot be a one-size-fits-all approach in addressing issues such as base erosion or, in particular, the exchange of information (EoI). With this in mind, solutions should also be crafted through the lens of local realities and take into account local sovereignty.
Regional involvement with global tax organisations, forums and multilateral instruments
As a starting point and for context, it is important to be mindful of the Central American countries' involvement in international tax organisations and forums, and their adoption of international instruments.
None of the Central American countries are OECD members, but Costa Rica is in discussions to join – after membership discussions with the OECD Council opened on April 9 2015, a roadmap outlining the process Costa Rica must follow was issued on July 15 2015 – and is to date the fourth Latin American country to pursue membership, following in the footsteps of Chile and Mexico (members since 2010 and 1994, respectively) and Colombia (opened discussions in 2013). Panama, Costa Rica, the Dominican Republic, El Salvador and Guatemala are members of the Global Forum on Transparency and Exchange of Information. Costa Rica and El Salvador are deemed compliant with the minimum international standards of transparency. And then there is the case of Panama, which is particularly interesting given its importance as a financial centre. It is worth mentioning the country's commitment to pass the Phase 1 review of the Global Forum's peer review process that evaluates the legal and regulatory framework in connection with the jurisdiction's compliance with the standards of transparency and EoI on request. Panama took the following steps in April 2015:
It accelerated the implementation of the custody regime for bearer shares. The compliance due date for bearer shares certificates issued before the law's effective date (May 4 2015) is now December 31 2015, instead of August 2018. These will have to be delivered to a custodian or replaced by registered share certificates.
A new anti-money laundering and terrorist financing (AML) regime was introduced to allow access to the final beneficiary information. It was supplemented on August 21 2015 with the issuance of 14 resolutions by the Ministry of Economy and Finance including AML guidelines and requirements directed to specific activities and sectors (for example, construction companies, attorneys, certified public accountants).
Penalties for non-compliance with certain corporate record-keeping obligations were also introduced.
With these changes, in addition to its existing bilateral undertakings to exchange information (29 such treaties and agreements have been signed to date), Panama should be able to move to the Phase 2 review which looks into the implementation of the framework in practice and rates the jurisdiction's overall compliance with the standards. However, as reality could demonstrate, standards and expectations are sometimes not equal for all reviewed parties.
Costa Rica, El Salvador and Guatemala have signed the OECD Multilateral Convention on Mutual Administrative Assistance in Tax Matters which provides for EoI foreseeably relevant in the administration or enforcement of taxes. This convention is one of the possible legal frameworks to implement the Standard for Automatic Exchange of Information in Tax Matters (Common Reporting Standard (CRS)) developed and approved by the OECD Council on July 15 2014 in response to a request made by the G20 countries. The standard has been described as a global 'FATCA-like' regime. Costa Rica was the first country from the region to commit to automatic exchange of information (AEoI). It endorsed the OECD Declaration on Automatic Exchange of Information in Tax Matters in May 2014. The country modified its tax code in May 2015 to facilitate its implementation and signed the Multilateral Competent Authority Agreement (MCAA) in June 2015. Costa Rica, which may be deemed an 'early adopter' in the region, committed to all these important processes in the absence of any local clarity on its practical and realistic capability of completing the exchanges. The protection and related privacy rights of the data to be collected to this end is still uncertain.
Key BEPS issues and related policy changes
At a time when the OECD is about to issue its final BEPS report on 15 action items with recommendations on complex and controversial issues, taxpayers should consider some of these actions items in the context of the local landscape.
Action 1 (Addressing the tax challenges of the digital economy)
There are no specific provisions with respect to the digital economy included in the tax legislations of Central America. The local taxation of digital goods and services when the seller does not have local presence is therefore very limited. Where transactions are taxable, there is generally a lack of appropriate mechanisms to allow non-domiciled entities to report and pay their tax liabilities. While authorities grapple with the new challenges of the digital economy, the lack of experience in dealing with such issues means there is a limit to the understanding and technical capabilities at the authority level to comprehend the issues and requirements to deal with this new model of economic transaction.
Action 3 (Strengthening controlled foreign corporation (CFC) rules)
Most of the countries of the region have a territorial system and the domestic legislations therefore do not include CFC rules. Even Honduras, which operates a worldwide system of income taxation, or the Dominican Republic or El Salvador, which have some extended definitions of local sources that cover certain types of foreign passive income, have no CFC rules. This is an alien concept to the local authorities and taxpayers. In spite of this, some of these jurisdictions, which already struggle to deal with their domestic collections, are considering including such rules.
Action 4 (Limiting base erosion via interest deductions and other financial payments)
The Dominican Republic has thin capitalisation rules with a debt-to-equity ratio of 3:1. Furthermore, it adopted a complex rule that establishes a limitation on interest deductions if the corporate income tax rate in the jurisdiction of the lender is lower than the 28% income tax rate applicable in the Dominican Republic.
In Costa Rica, the Executive Branch sent to Congress in August 2015 a Bill that would replace the Income Tax Law, which includes (i) thin capitalisation rules with a non-typical debt-to-equity ratio of 2:1; and (ii) a rule for the non-deductibility of expenses paid to entities that are residents of tax havens or non-cooperating jurisdictions (defined as jurisdictions where the corporate tax rate is less than 40% of the Costa Rican corporate tax rate (30%); or which do not have a TIEA or double tax treaty including EoI provisions). To deduct expenses, taxpayers would bear the burden of proving that a given expense corresponds to a transaction actually carried out and may be subject to undefined or ambiguous criteria of the tax authorities.
El Salvador has thin capitalisation rules with a debt-to-equity ratio of 3:1. In addition, payments to tax havens are subject to increased withholding tax rates. Thin capitalisation rules also apply in Guatemala.
Unfortunately, most of these provisions were simply adopted as general 'templates' borrowed from other countries' experiences and recommendations from multilateral organisations, without truly analysing the impact they may have on their domestic economies and the realities of their taxpayers. In countries where the economies depend on industries that need constant access to capital (for example, agriculture and tourism) and that are subject to uncontrolled factors (for example, geography and weather) to survive, not recognising that debt-to-equity ratios may impose additional increased costs of operation is an example of how local authorities adopt rules because they are 'trendy' or in vogue and "it's what others are doing", rather than basing them on a comprehensive plan to promote economic growth.
Action 6 (Preventing treaty abuse)
Panama has the most extensive treaty network with 15 double taxation treaties (DTT) in force to date.
Costa Rica has one DTT in force with Spain, three DTTs signed but not in force (with Germany, Mexico and Romania) and is engaged in several DTT negotiations (for example, with the Netherlands and Switzerland).
El Salvador has one DTT in force with Spain.
The Dominican Republic has two DTTs in force with Canada and Spain.
In March 2015 Guatemala signed a DTT with Mexico which is not yet in force.
Nicaragua and Honduras have no DTTs.
Some of the DTTs adopted general anti-avoidance rules (GAAR) – similar to the ones recommended by the BEPS project (limitation of benefits, purpose test). A number of the region's DTTs also make express references to the domestic legislation's anti-avoidance rules to ensure the treaty provisions do not impede their application. In this respect Costa Rica, the Dominican Republic, El Salvador and Honduras have a substance-over-form principle.
But is it worrisome that to date, with very few exceptions, the authorities have not developed the necessary technical resources and expertise to effectively deal with these new complex tax rules and concepts. Despite what may be argued by local governments, this should not be a 'chicken or egg' discussion where one can pick and choose one or the other. Issuing rules without having the proper technical capabilities to deal with their consequences is not the right order of ideal evolution and may be irresponsible. One does not first manufacture products, sell them and then start testing them. Doctors do not perform brain surgery until they have completed the necessary training; Merely being a doctor is not enough and specialisation is also needed. The same should apply to taxation. There has to be a logical order and process between the definition of the infrastructure and resources necessary to implement laws and their enforcement.
Actions 8, 9 and 10 (Changing transfer pricing on intangibles, documentation requirements, risks and capital and other high-risk transactions)
Panama, Costa Rica, El Salvador, Guatemala, Honduras and Dominican Republic have TP rules in force, which are largely in line with the OECD TP guidelines. Nicaragua's formal regime is still pending. And in Costa Rica, existing rules originate from a very unique legal precedent. The OECD Guidelines can be applicable to TP provisions because they are either formally incorporated by reference in the local regulations (as in Panama, El Salvador and the Dominican Republic) or are widely used in practice by the local tax authorities (Costa Rica).
But these countries have barely been able to fully implement a TP system under existing OECD Guidelines. And now they will have to deal with the pressure of adopting new rules that would require even more complex technical capabilities and infrastructure to be properly implemented and managed.
Action 13 (Transfer pricing documentation and country-by-country reporting (CbCR)
The requirement to maintain a master file and CbCR would entail amending domestic laws across the region. Taxpayer information is protected and in principle remains confidential, except in the case of fraud or as a result of other criminal proceedings. This should apply to information collected as part of CbCR. The tax authorities would only disclose taxpayer information to other tax authorities within the frame of a treaty or EoI agreement.
This would require major adjustments to be properly implemented. The reality is that these jurisdictions still do not have clearly defined documentation requirements even under current standards. To date, countries like Costa Rica (which, as noted is on track to become a full OECD member) passed rules requiring compliance with the arm's-length principle, but without then clearly defining, more than two years after, how taxpayers should document their transactions, creating a state of legal limbo. Some countries require preparation and maintenance of annual documentation and others additionally require the annual filing of TP information returns. But the new added requirements would likely over-stretch the already limited internal capacity to deal with existing rules.
The real needs of Central America
The OECD's BEPS project contains practical guidelines and actions to minimise base erosion and profit shifting issues that are more focused towards dealing with the matter at a broad, cross-border level. But the problem is that the concept of 'guidelines' or 'recommendations' is not being interpreted as such by some. They are taken as binding and mandatory by authorities or even as excuses to shape local policy.
As an example, Central America is primarily a recipient of services (for example, consulting, know-how, technical support). Some of the countries contain provisions allowing them to tax non-residents on services performed abroad and used locally, but the rules could be improved. There is no BEPS action item addressing this issue of supply of (traditional) services and how it contributes to eroding the tax base of countries. Even before dealing with this issue, the countries in the region should focus on enhancing existing domestic collection and on implementing or enhancing existing rules, rather than adopting tax trends that are not tailored to their situation (for example, by complicating access to foreign financing to fund local business development).
Developing countries should therefore only adopt such actions to the extent they respond to their specific fiscal problems, which entails making some adjustments to link them to the local reality and needs, while understanding that this process requires investment in resources and knowledge before changes are enforced.
Foreign investment plays a large role in total revenues and it is attracted in part by the fiscal incentives available under the domestic laws of each country. As a consequence, Central American taxation issues primarily derive from domestic base erosion rather than international profit shifting.
This triggers the question as to whether BEPS should be a priority in the tax policy agendas of the Central American countries, which face issues far more basic than those of developed countries.
In this respect, we view these as among the key challenges that Central American countries face today:
The absence of simple yet robust tax systems with clear and precise regulations that facilitate compliance.
Difficulty to predict the tax treatment applicable to transactions. Legal uncertainty is a reality.
If these countries' authorities lack resources and struggle to deal with a territorial system, shifting towards worldwide income principles is not the solution to fiscal deficits.
An overall difficulty in paying taxes. It is remarkable to see how the Central American countries, with the exception of Guatemala, rank really low in the World Bank's 'Paying Taxes' annual survey, which ranks 189 economies and measures the ease of paying taxes. According to the 2015 survey, Guatemala ranks 54th, the Dominican Republic 80th, Costa Rica 121st, Honduras 153rd, El Salvador 161st, Nicaragua 164th, Panama 166th.
Lack of well-defined policies that contain control methods and risk management strategies to maximise the limited resources of the tax authorities.
Absence of high performance units that focus on high risk segments and taxpayers.
Lack of consolidated tax legislation, which is particularly acute in the case of Honduras but also affects other jurisdictions such as Panama.
Corruption within a government can weaken the overall system and subsequently jeopardise the attraction of foreign investments. The Central American countries score low in the Corruption Perceptions Index of Transparency International, which ranks countries based on how corrupt their public sector is perceived to be. The last survey evaluated 175 countries and territories graded on a scale of 0 (highly corrupt) to 100 (very clean). According to the 2014 survey, Nicaragua ranked 133rd with a score of 28, Honduras 126th with a score of 29, Guatemala and the Dominican Republic 115th with a score of 32, Panama 94th with a score of 37, El Salvador 80th with a score of 39 and Costa Rica 47th with a score of 54. Guatemala provides an extreme example of this issue. In April 2015 the UN-backed International Commission against Impunity, along with the country's prosecutor, revealed a criminal network known as La Línea by reference to the telephone number that importers were required to dial as part of a scheme in which they could pay a bribe to this organisation to avoid paying customs duties. Several public servants were initially arrested including the tax authorities' superintendent. The country's vice president and president were forced to resign and are now behind bars facing a trial.
Additionally, a common issue shared by the Central American countries that facilitates base erosion is the lack of qualified personnel in the tax authorities. There is a general need for more investment in the training and recruiting of expertise that can ensure that fundamental guarantees and taxation principals are taken into account during the elaboration and the establishment of domestic tax provisions and collection efforts, which in turn enhances the possibility of developing tax regimes more structured and consistent with the minimum international requirements.
Matters of this nature are not of great concern to developed countries as they have already overcome most of these capacity building issues, though some big economies have still expressed concerns with some of the OECD proposals. Central American countries still have to address these areas and, until they can do this effectively, they will not be able to meaningfully stem base erosion that affects their national revenues.
Despite the gulf in the levels of technical expertise available in developed and developing countries, global tax trends still impact the way the tax authorities apply existing tax rules in Central America. There have been cases where the tax authorities have applied concepts they may not have fully grasped and which were not even formalised in the law in the first place. As an example, there were no official transfer pricing rules in Costa Rica until September 2013. Up to then and as of 2003, the tax authorities had instructed its auditors to review inter-company transactions under the general economic reality and by applying substance-over–form and OECD principles. It resulted in abusive positions taken by the tax authorities that conflicted with the rule of law. And several changes to domestic tax legislation and policy have been ushered in or justified using BEPS, even though final recommendations have not yet been issued.
The rule of law is actually increasingly being challenged. Tax bullying is having cascade effects. Local countries get bullied by the global forums and organisations into assuming recipes that do not fit with their realities. Taxpayers are in turn bullied by the local tax authorities. As an example, in September 2014 the Constitutional Chamber of the Supreme Court of Justice of Costa Rica ordered the tax authorities to temporarily suspend the issuance of letters of determination while a case on the matter was pending. To date the case has not been resolved and no ruling has been rendered. In this context, the tax authorities have been forcing taxpayers to make extra-judicial payment agreements at the administrative level to avoid being indicted for tax fraud, which creates friction with the rule of law.
The flow of taxpayer information that authorities will receive in the upcoming years is going to increase dramatically with the automatic exchange of information becoming the norm when it comes to tools to fight tax evasion. But the current systems are not ready to receive or deliver it properly. Question marks also hang over whether authorities in the region are suitably prepared to guarantee the confidentiality and legitimate use of all the information they will be receiving. In a region where, unfortunately, crimes such as kidnapping are still a reality, misuse of financial information is a risk that transcends tax considerations.
In conclusion, global tax trends will continue to have a growing and significant impact on businesses and individuals in Central America. Some of these trends, such as the BEPS project, do not seem to be sufficiently tailored and adapted to the immediate and pressing needs of the region. Others such as the automatic exchange of information will test the countries' capacity and commitment to respect and uphold the rule of law.
The key issues faced by the Central American countries in the tax space are the weakness of the tax and judicial systems, the lack of technical expertise of the tax authorities, and corruption. The priority should be the strengthening of the bases of local institutions and then focus should be shifted onto broader concepts.
Some global tax trends will have unintended consequences that could raise constitutional rights issues and this could create increased space for tax bullying across the region.