We are observing a growing influence of global tax trends in Central America. Their impact on businesses will be significant over the coming years. Words and acronyms that were completely alien in our region, such as transfer pricing, tax treaties, tax transparency, OECD, BEPS, substance over form, and so on, are now increasingly becoming more and more relevant and influential in the way we do business even in the smaller economies. We are also living in a new era where tax policy is more and more driven by the proposals of multilateral organisations which none of our countries are even parties to. Such is the case of the OECD, which has become the beacon for guidance that is increasingly being followed and used by our governments; or by the extra-territorial laws of countries such as the US or some EU countries, where concepts of sovereignty and local rules are becoming more irrelevant when in pursuit of implementing their own domestic policies.
The international tax policy context is at a watershed. Major changes in international taxation standards and the general framework of taxation have occurred. More changes are to come and it will have a profound and lasting effect on businesses and individuals. Keeping track of all the tax policy changes at a global and local level will be critical.
One of the key drivers in international tax matters has been the OECD which influences the tax policies of many countries. Over the past few years, the peer review process conducted by the OECD's Global Forum on Transparency and Exchange of Information has caused many countries to implement international standards of transparency and exchange of information. The discussions are now focusing on the OECD's base erosion and profit shifting (BEPS) project and related action plans and recommendations. The OECD is evolving towards being a global tax organisation and its initiative on BEPS is having a strong impact on the tax policy agendas of many of our countries.
Most of the Central American region countries have started making modifications to their tax legislation to include measures addressed by the OECD's BEPS project. Specifically, general anti-avoidance rules (GAAR), information exchange, increased transparency, limitations to the deductibility of intragroup interest payments, and other topics of the BEPS project have been part of the recent tax reforms of the Central American countries. This trend will continue and BEPS-related matters will undoubtedly be on the agendas of current and future tax reforms in this region.
Increased transparency and exchange of information
Transparency and substance have been major components of the international tax debate of the past decade and are now one of the pillars of the BEPS action plan. These topics are related to the negotiation of tax treaties or agreements that foster an effective exchange of information and collaboration between tax authorities.
In terms of domestic laws they relate to more information being requested from taxpayers. The measures generally aim at improving tax audits and tax collection. In recent years, most of the Central American countries have incorporated measures in their domestic legislations to enhance transparency and substance. They have also started to enter into double taxation treaties (DTT) or tax information exchange agreements (TIEA).
Measures in the domestic legislation to enhance substance and transparency
Costa Rica and the Dominican Republic are the only countries to have had a substance over form and economic reality principle before 2000. In Costa Rica it has been actively used by the tax authorities to re-characterise transactions and assess taxes for more than 10 years. Costa Rica actually illustrates the challenges entailed by the changing environment and how the local tax authorities understand (or in certain cases, misunderstand) and apply international tax standards. The extensive and uncontrolled use of the substance over form principle in this country has resulted in abusive positions taken by the tax authorities that conflict with the rule of law and taxpayers' rights.
As an example, there were no official transfer pricing rules in Costa Rica until September 2013. From 2003 up to then, despite the lack of any rules or even technical guidance or capacity, Costa Rican tax authorities instructed its auditors to review inter-company transactions under the general economic reality and substance over form principles. This resulted in very complex, confusing and especially expensive tax adjustments for companies doing business in the country. Most unfortunate is the fact that as a result of the lack of understanding of the technical issues, some cases were confirmed by several rulings from administrative and judicial courts. Also, the power of tax authorities to issue interpretative rulings that resulted in the adoption of foreign technical rules such as the OECD Transfer Pricing Guidelines was supported by the Constitutional Chamber of the Supreme Court.
El Salvador included a substance-over-form principle in its legislation in 2000. Honduras followed the path in 2011.
As a result, in Costa Rica, the Dominican Republic, El Salvador and Honduras, taxpayers should generally not expect the tax treatment to necessarily follow the legal characterisation of a transaction. The tax authorities will consider the substance and the underlying economic reality. They will reject or disregard a transaction if they consider that the underlying acts or agreements do not reflect the reality of the transaction. Concepts such as business purpose are also starting to appear in local rulings.
Panama does not have a general anti-avoidance rule. A substance over form principle is included only for social security contributions in order to allow the authorities to investigate the reality of the professional relationship of the individuals. This being said, the tax authorities are now in practice asking taxpayers to support the transactions that generate, for example deductible expenses with more documentation than just mere contracts or invoices. This position is taken particularly for services fees paid to foreign entities. The approach of the Panamanian tax authorities echoes the position of the UN, which in line with BEPS, views the use of services to erode the tax base as one of the major concerns of developing countries.
Furthermore, a trend to request more information from taxpayers is currently developing in the region.
In Costa Rica, the tax authorities issued a resolution in August 2014 (now in effect) which requires so-called "large national taxpayers" to update their relevant tax information using a newly enacted and mandatory web-based platform called AMPO.
The information, which has to be updated when changes occur, is related to the identification of shareholder of the entity, accounting information, mergers, extraordinary contributions or withdrawals of capital, payment of dividends, retained earnings, equity participation in other entities amongst others.
The information on shareholders is causing some controversy in the local business community. A specific resolution requiring corporate taxpayers to submit special return disclosing the name of their shareholders was actually expected to be released in February 2014. It ended up not being published, but this August 2014 resolution makes the disclosure of the shareholder-related information mandatory. Once the AMPO platform is made available to taxpayers, they will have 15 business days to comply and upload the relevant tax information. The tax authorities have not yet communicated such date of availability.
The obligation to disclose the shareholders of business entities also exists in El Salvador and the tax authorities have recently emphasised this compliance duty.
It is also worth mentioning that Panama introduced a law in August 2013 providing for a custody regime for bearer shares. Ending a long tradition for confidential ownership structures. The law will enter into force on August 2015. Bearer shares issued after the entry into force of the law must be delivered to a custodian together with an affidavit from the owner of the shares including specific identification information. This obligation must also be fulfilled with respect to bearer shares issued prior to the law's entry into force, but following the expiration of a three-year transition period.
New withholding taxes which are also an indirect way of gathering financial information on taxpayers are on the rise. El Salvador introduced the Financial Transactions Tax Law (FTTL) on July 31 2014 which establishes a 0.25% tax on certain financial transactions and a 0.25% withholding tax on cash deposits, payments and withdrawals of more than $5,000. The taxes withheld are creditable against any tax administered by the tax authorities within a two year period of the withholding date.
In the same vein, the tax authorities in Costa Rica issued a resolution on August 18 2014 (effective as of October 1 2014) which requires financial entities processing payments made through debit or credit cards to withhold 2% of the amount paid or remitted to the payee. The amounts withheld are considered as advance payments of the income tax due by taxpayers.
From a tax policy perspective, the purpose of these withholdings in El Salvador and Costa Rica is to provide financial information to the tax authorities. In practice, these types of actions will result in more establishments and consumers to "flee to cash". For day-to-day merchants, shops, restaurants, and so on, the obligations may force them to avoid using credit cards altogether. And for consumers, this may result in an onerous charge, since a big portion of the population in this region is only subject to income tax from its salary and compensation amounts.
DTTs and TIEAs
After being completely disconnected from the world of tax treaties, over the past five years the Central American countries, with the exception of Panama, have timidly increased their tax treaties and especially their exchange of information networks.
Using the OECD and its pressure for more transparency in the tax environment, Costa Rica now has eight exchange of information agreements in force (with Argentina, Australia, Canada, France, Mexico, Netherlands, Norway and the US), 11 exchange of information agreements signed but not yet in force (for example, Denmark, Ecuador, Finland, South Africa, Spain and Sweden), one DTT in force with Spain, three DTTs signed but not yet in force (with Germany, Mexico, Romania) and three DTTs under negotiation (with the Netherlands, Switzerland and Vietnam). Local policy has been driven by an interest to simply comply with OECD recommendations and not, for example, by a rationale to increase foreign investment and local development.
It is important to mention that Costa Rica was one of the first small economies to sign the OECD Multilateral Convention on Mutual Administrative Assistance in Tax Matters which is already in force. The convention provides for an exchange of information, applying to any information that is foreseeably relevant for the administration or enforcement by the parties of their domestic laws concerning the taxes covered by the convention. Such exchange of information can be upon request, automatic or spontaneous. The convention also provides for simultaneous tax examinations, joint tax examinations abroad, assistance in the recovery of tax claims including conservatory measures, and the servicing of documents. It also signed a reciprocal intergovernmental agreement with the US for the implementation of FATCA.
Panama, with a clearer policy to enhance international relations and improve foreign investments, now has 15 DTTs in force (with Barbados, France, Ireland, Israel, Luxembourg, Mexico, Portugal, Spain, South Korea, Czech Republic, the Netherlands, United Arab Emirates, Qatar, Singapore, and the UK). It is the country in Central America with the most extensive treaty network. The treaties generally follow the OECD Model with some deviations in permanent establishment clause, royalties, and services clause, among others. Panama also entered into several exchange of information agreements (with Canada, Finland, Iceland, Norway, Sweden and the US which are in force, and with Denmark, Faroe Islands and Greenland which are signed but not yet in force) and more are under negotiation. It has also reached, in substance, an intergovernmental agreement with the US for the implementation of FATCA, which is expected to be signed no later than December 31.
Guatemala has eight exchange of information agreements signed but not yet in force (with Australia, Denmark, Faroe Islands, Finland, Greenland, Iceland, Norway and Sweden), two DTTs under negotiation with Mexico and Spain. It has also signed the Multilateral Convention on Mutual Administrative Assistance in Tax Matters.
El Salvador has one DTT in force with Spain. Because of its current hardline, left-oriented government, it is not clear what their tax policy with the more traditional countries is going to be. Foreign direct investment is in decline. So, do not be surprised if, following in the footsteps of their most influential ideologically aligned countries of the south, they start negotiating treaties with the likes of Cuba, Iran, Russia and North Korea.
The Dominican Republic, in spite of being one of the largest economies in the region, with strong ties to the EU, is still behind the curve. It has one exchange of information agreement in force with the US and two DTTs in force with Canada and Spain. It also reached, in substance, an intergovernmental agreement with the US for the implementation of FATCA, which is expected to be signed no later than December 31.
It is important to take into account that the US FATCA initiative has dramatically changed the framework to exchange information and it will have an impact in Central America. The full version of the global standard of automatic exchange of financial information in tax matters was released by the OECD on July 21 2014. This standard is based on the intergovernmental agreements approach for the implementation of FATCA. More than 65 jurisdictions have committed to implementing this new standard including from our region, Costa Rica, which usually seeks to become an early adopter of these initiatives.
General anti-avoidance rules
Most of the DTTs signed by countries in this region have adopted general anti-avoidance rules (GAAR) – similar to the ones recommended by the BEPS project – that empower tax authorities against scenarios that they considered as treaty abuse. This includes limitation of benefits (LoB) provisions included in the DTT concluded by the US, as well as purpose test anti-abuse rules according to which the treaty benefits will be denied where one of the main purposes of the arrangement is to secure specific DTT benefits.
A limitation of benefits clause is included in the Panama-Mexico DDT. Purpose test provisions are included in most of Panama's DTT (for example, the treaties with Spain, France, Italy, Israel, UK, Portugal), in the El Salvador-Spain DTT and in the Dominican Republic-Spain DTT.
A number of the region's DTTs also make express references to the domestic legislation anti-avoidance rules to ensure the treaties do not impede their application. These references are included in the following DTTs: Costa Rica-Germany, Costa Rica-Spain, Dominican Republic-Spain, Panama-Israel, Panama-Italy, Panama-Netherlands and Panama-Portugal.
Transfer pricing is one of the most fundamental changes in our region and that is completely changing not only our tax environment, but also the way companies generally do business and organise their supply chain structures in our countries. All Central American countries now have some type of transfer pricing rules in force, which are based on OECD principles.
The OECD transfer pricing guidelines will play a very important role as soft law in the region because they are either formally incorporated by reference in the local regulations (as is the case in Panama and El Salvador) or are widely used in practice by the local tax authorities (for example in Costa Rica), in lieu of more specific domestic legislation and guidelines.
The BEPS action plan focuses on improving the rules on transfer documentation to enhance transparency for administration tax purposes. It will result in a new chapter of the OECD guidelines on transfer pricing which will become soft law in Central America. This triggers a number of issues in the local landscape such as the ability of the tax authorities to preserve the confidentiality of the information they will be receiving.
Limitation on interest deductions and payments to tax havens
Limitations on interest deductions are also on the agenda of Central America's policy makers.
The Dominican Republic passed a tax reform, in effect since November 2012, which introduces thin capitalisation rules with a debt-to-equity ratio of 3:1. It further restricts the use of foreign loans with the deductibility of interest expenses of a Dominican entity in connection with loans from foreign lenders being limited 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.
Costa Rica has a draft tax reform before Congress which includes a cap on interest deductions that can be taken in a given year. Under the draft Bill the amount of the deductible interest cannot exceed the amount resulting from earned interest multiplied by three times capital over equity (earned interest × 3(capital/debt).
Payments to tax havens are also being restricted in several countries. In El Salvador, for example, they are subject to increased withholding tax rates. The Salvadoran tax authorities have a list of tax havens which is updated annually and it now includes even locations such as Delaware and Florida, amongst others. The same applies in Nicaragua but the local tax authorities have not yet published a list of these tax havens to apply the higher rate.
In Costa Rica a draft tax reform now being considered by Congress contemplates a presumption whereby expenses paid to tax havens or non-cooperative jurisdictions defined as such by the tax authorities would not be deductible for corporate income tax purposes.
Increasing revenues are also on the agenda of policy makers.
El Salvador approved on July 31 2014 amendments to its income tax law. It created an alternative minimum tax of 1% on net assets. The income tax that has to be paid is now the higher amount resulting from the computation of the income tax and the alternative minimum tax. The reform also eliminated a number of income tax exemptions that were available for printing activities.
Honduras adopted a tax reform on December 30 2013 which entered into force on January 1 2014 under the Law on Public Finances, the Control of Tax Exemptions and Anti-Evasion Measures. This law introduced an alternative minimum income tax of 1.5% of gross income. It also eliminated income tax exemptions and only kept limited exceptions (for example, free trade zone activities and renewable energies).
Continuing to adapt
Central America is embracing the global trends set by the OECD towards greater transparency and substance. The flow of taxpayer information the tax authorities will be receiving in the coming years is going to increase exponentially. Where all that information will end up and how it will be used is still to be seen. But it is clear that taxpayers will have to give much more attention to the substance of their transactions and structures that will now be subject to enhanced scrutiny by the tax authorities.
The aggressiveness of the tax administrations we have observed in the past couple of years will continue to grow. Since cutting expenses is not a popular policy in small GDP countries, increasing revenue is going to continue as the preferred course of action in the region. This, compounded by judicial systems that are lacking significant technical expertise to fully comprehend this new landscape that transcends domestic legislations, will create a real challenge for taxpayers and the application of the rule of law that is supposed to exist under the constitutional models of all these countries. More focus on overall compliance, prevention and risk management will need to come to the forefront of business strategies because, as history has taught us, the future is for those willing to quickly adapt to the new realities.