|The tax reform Bill referred to in this text received approval while the article was being written. This marks the next step in the reform package’s journey to implementation, though it must go through further processes at the Constitutional Court before promulgation, publication and enactment.|
Depending on the effective date of each new rule, corporate taxpayers and their shareholders will have different (larger or smaller) windows of opportunity to react.
Where we stand and what to expect
The Lower House of Congress approved the Bill by a large majority. The government and members of the Senate's Finance Committee agreed on a memorandum of understanding with mark-ups to the Bill. In August 2014, the revised Bill was then favourably voted in the Senate floor and is now likely to follow suit in Chile's Lower House of Congress. At the time of publishing, the expectation is that the Bill will be approved by a large majority in both houses of Chile's Congress in close proximity.
Despite improvements being made, the business community and tax practitioners remain bitterly critical of the Bill. Not least, it has been singled out as one responsible factor for the recent downturn of the Chilean economy.
The new rules will enter into force on different effective dates, starting from the month after enactment through to January 1 2018.
The Bill proposes several, complex changes in different areas including a new general anti avoidance rule (GAAR); an increased combined corporate and shareholder tax rate on accrued business profits from 20% up to 27% or 35%; two new shareholder taxation mechanisms from which corporate taxpayers will have to elect – including one which may result in a 44.45% total tax burden; anti-deferral or controlled foreign corporation (CFC) legislation on foreign outbound investments; a new thin capitalisation rule; and new goodwill amortisation rules.
The tax reform focuses heavily on income taxation, and more specifically on the (corporate and shareholder) taxation of business income.
While the tax reform will have repercussions among both local and foreign businesses, some changes will specifically impact multinational companies and cross-border transactions. This is the subject on which this article will focus.
Rules impacting multinational companies and cross border transactions
After enactment of the tax reform, multinational companies and several cross-border transactions will face new restrictions, reporting obligations, specific anti-avoidance mechanisms, increased screening and tax audit activity by the Chilean Servicio de Impuestos Internos. Changes that will have an impact on multinational companies and cross-border transactions include:
i) New controlled foreign corporation (CFC) rules – effective January 1 2015;
ii) New rules on tax deductibility of outgoing intercompany payments – effective January 1 2015; and
iii) A new thin capitalisation rule – effective January 1 2015.
i) New CFC rules
The proposed legislation provides that foreign passive income obtained by Chilean taxpayers through controlled foreign corporations (CFC) shall be "deemed as accrued or received" and will be taxed accordingly, under certain circumstances.
What is a CFC: In order for foreign passive income to be computed in Chile on accrual basis, there must be a CFC. In Chile, a CFC is defined as any foreign vehicle with or without legal personality, fund, trust, and so on, in which upon closing or at any time during the taxable year one Chilean resident shareholder (or two or more Chilean resident, related shareholders) owns 50%+ of the total share capital, profits or voting power of its stock. In addition, foreign vehicles residing in low or no tax jurisdictions will be deemed CFCs, except if evidence is given to the contrary.
A foreign entity that is not a CFC is treated for tax purposes as a separate entity and is subject to the general tax rules; that is, foreign source income is only taxable in Chile as and when received (cash basis).
Foreign passive income: Foreign passive income includes interest, dividends, royalties, rents (except those obtained by active real estate companies), income from intercompany transactions with Chilean resident related entities, and net gains from the sale of assets producing these income flows or sales of non-income producing assets.
How and when is foreign passive income computed: If a foreign entity is a CFC, each Chilean resident shareholder must include in income the shareholder's pro rata share of foreign passive income. That is, passive income obtained by CFC is taxable to the Chilean resident shareholder even if not effectively distributed by the CFC.
Chilean resident shareholders may claim an indirect foreign tax credit for foreign income taxes paid by the CFC on accrued earnings. But any foreign taxes payable abroad on dividend distributions may not be creditable if the distribution is made in a year different from that in which the underlying income was accrued and included for Chilean tax purposes. This may create a mismatch and potential double tax issues.
On a subsequent distribution of previously taxed income, no further Chilean taxation applies.
Passive income shall not be includable in the shareholder's taxable income on accrued basis when i) the total computable foreign passive income earned by a CFC is less than 10% of its total revenues, or ii) the shareholder's income is less than 2400 UF ($100,000) per year.
CFCs earning 80%+ of foreign passive income, will be deemed to earn 100% of foreign passive income (that is, 100% of their income is includable on accrual).
A CFC's foreign passive income shall be calculated following Chile's taxable income determination rules. But CFC losses shall not be deductible by the Chilean investor.
The Chilean penalty taxation imposed on non-deductible cash items will also apply to CFCs.
Tax-haven resident CFCs will face two special deeming rules by default, that is, except if evidence is given to the contrary: i) they shall be deemed to earn 100% in foreign passive income; and ii) they shall be deemed to earn annual foreign passive income no less than the average interest rate charged by financial entities in the CFC's residence country times the higher of a) the pro-rated stock basis in the CFC or b) the pro-rated book value in the CFC.
The tax reform also introduces a new reporting obligation on foreign outbound investments (effective January 1 2017), which will help enforce the new CFC rules. Outward investments going through or into blacklisted territories will be subject to increased reporting.
ii) New rules on tax deductibility of outgoing intercompany payments
Outgoing payments owing to foreign resident related-parties for services classified in section 59 (interest, royalties, insurance premiums, freight, lease payments), may only be deductible i) on a cash basis, and ii) insofar as the applicable withholding tax, if any, has been reported and paid. If the outgoing payment enjoys a withholding tax exemption, such will have to be evidenced.
Accordingly, if interest (or other outgoing cross-border payment) owing to foreign resident related parties has not been paid or has not satisfied the applicable withholding tax, shall be added back to the Chilean debtor's taxable income (if already deducted in the Profit & Loss Statement).
iii) New thin capitalisation rule
The tax reform Bill also substitutes the current thin capitalisation rule for a new one. This new rule provides that outgoing interest paid to foreign resident, related parties, arising from liabilities and debt transactions classified in section 59 N°1 of the Income Tax Act (that is, the interest on which is subject to a reduced 4% withholding tax), will be subject to a single 35% penalty tax if it qualifies as excessive interest.
The 35% penalty tax on excessive interest will be borne by the Chilean borrower. It must be reported and paid by filing an annual tax return in April after the year in which the excessive interest is paid. When paying the interest, the 4% withholding tax reported and paid is a credit against this 35% penalty tax.
Excessive interest is that which arises from "excess indebtedness" – that which exceeds three times the tax-related equity (CPT) of the Chilean resident borrower.
Unlike the previous rule – where the test was only required in the year in which new qualifying debt was incurred – the new thin cap test must be performed upon closing (December 31) of every year in which Chilean resident borrowers pay qualifying interest (that is, interest paid to foreign resident, related parties subject to 4% or 0% withholding tax).
For purposes of the 3:1 debt/equity test, equity is the borrower's tax-related equity as of January 1 of the year tested adjusted by a weighted average calculation based on equity contributions, returns of capital and profit distributions made in the year. "Annual indebtedness" includes virtually all liabilities of the borrower – foreign or local, related or unrelated – which also must be adjusted by a weighted average calculation based on the debts lasting throughout the year. This is also a difference with the previous rule where the only computable debt was that the interest on which was subject to the reduced 4% interest withholding tax. Liabilities incurred by a foreign branch or PE that the borrower maintains abroad and capitalised interest – accrued, unpaid interest, which in turn do accrue interest – shall also be included.
Foreign, related-party creditors include i) black-listed entities under section 41-D (old list); ii) blacklisted entities under section 41-H (new list); iii) related entities with 10%+ of stock ownership relationship; iv) back-to-back transactions except where the guarantor is a non-related entity; v) debt instruments acquired by third parties but subsequently transferred to related parties; and vi) foreign entities the debt transactions of which are not reported in the annual Information Return referred to below.
An annual Information Return will be mandatory for borrowers to file. Failure to do this will result in the unreported debt to be deemed "related" – and its interest possibly excessive. Accordingly, interest paid to foreign related parties will be tax deductible if it satisfies the general requirements for deductibility – even if excessive. But, when excessive, interest will be subject to a 35% single penalty tax. This tax will be a deductible expense.
An incomplete or false Information Return may be subject to significant fines and even imprisonment.
This anti-avoidance rule does not apply to certain qualified Chilean borrowers such as banks, insurance companies, Cajas de Compensación and other financing entities subject to regulatory supervision by the SBIF and SVS.
No grandfathering rule will protect related indebtedness incurred before the entry into force of this anti-avoidance rule.
Tips on the use of foreign, related-party debt financing into Chile
Multinational groups with Chilean subsidiaries currently funded with foreign, related-party debt – in cases where the subsidiary pays outgoing interest with a reduced 4% withholding – should now watch out for pitfalls that may unwantedly lead them to a situation of excess indebtedness.
Pitfalls to watch out for include: current year losses, dividend distributions, capital reductions, and new debt incurred in the year, whether local, foreign, related or unrelated. Any one or more of these events may put Chilean related borrowers in a thinly capitalised position, so related interest payments may face a 35% penalty tax in the hands of the borrower.
Possible cures against an unwelcome excess indebtedness position may include: capital injections, foreign for local debt swaps, and keeping earnings undistributed – although under Chile's new income tax system on accrued earnings this is something that may not be beneficial. Additionally, since the new thin cap rule applies to interest payments, a decision not to pay accrued interest may at least defer the penalty tax until subsequent years in which the borrower improves its debt to equity position. All the while, some related interest expense may not be tax deductible, but at least it will neither trigger the interest withholding tax nor the penalty tax on excessive interest. Finally, related, interest-free loans could also be a possible choice to consider, but we recommend careful evaluation because this option may fall contrary to Chile's transfer pricing rules.
Alberto Maturana is a partner in Baker & McKenzie's Santiago, Chile office. He practises mainly in tax and corporate law. Alberto is a permanent legal representative for numerous foreign companies doing business in Chile. He advises corporations and individuals from a broad spectrum of industries and is proficient in business structuring, foreign inbound/outbound investment, offshore intercompany transactions, as well as tax and estate planning. In addition, he counsels on mergers and acquisitions and matters involving contracts.
Alberto is a frequent speaker at a wide variety of tax conferences and has published numerous articles on Chilean taxation for foreign companies.