Chile: The correlation between deductible expenses and taxable income

Astrid Schudeck

Chilean tax experts were looking forward the decision of the Supreme Court on a case involving a relevant local company that was leveraged through its branch located in the Cayman Islands, with the purpose of making an investment abroad. The matter discussed relates to the deduction of the associated interest for Chilean tax purposes.

The referred decision was made public on July 23, and came to confirm the judgments of the Tax Court and of the Court of Appeals, both against the Chilean taxpayer.

The case under analysis involved the following main transactions: a) the local company registered a branch in the Cayman Islands, which was granted a loan; b) the loan proceeds were contributed by the branch to a subsidiary also located in the Cayman Islands; c) the branch took additional borrowing in order to refinance the initial debt; d) the Cayman Islands' subsidiary, with the same funds, acquired a foreign company, that was the owner of a Chilean operative plant.

The interest paid by the branch on the relevant loans was deducted by the local company in the determination of its taxable income in Chile. The Chilean Internal Revenue Service (IRS) objected to the referred deduction based on the lack of correlation between deductible expenses and the taxable income, because of the fact that the branch did not obtain income related to the interest for more than 10 years. The judicial decision was based on this argument, but also on the lack of legitimate business reason of the transaction.

In this author's view, the correlation between deductible expenses and taxable income conflicts with legal and administrative rules that represent a cornerstone of the Chilean tax system.

In fact, the referred correlation principle appears to have been artificially created by the Chilean tax authority with the purpose of requiring a return on investments materialised by taxpayers in foreign companies, an aspect that is out of the scope of our tax system. The Chilean Tax Law has never required that taxpayers effectively obtain a minimum return on this type of investments, in circumstances where the return depends on the risks associated to the nature of the transaction.

On the other hand, the Chilean IRS position is not consistent with its own administrative jurisprudence that states that the deduction of any interest related with investments in local companies depends on the tax treatment applicable to the future sale of such investment and not on the effective generation of income at the level of the investor. If the Chilean IRS expects to be consistent in the application of the principle under analysis, it must allow the deduction of interest from ordinary income in any case that such interest relates to a local investment that is able to generate income for the investor disregarding the taxation applicable on the sale of such.

It is difficult to infer the referred correlation principle from the Chilean Tax Law, particularly in the case of the foreign source income that is taxable in Chile as long as it is effectively perceived by the taxpayer, while expenses are deductible once accrued or paid, whatever occurs first. Branch income is the only exception to this rule. Apart from this case, there are other multiple examples where neither the Chilean law not the Chilean IRS has required a correlation between deductible expenses and taxable income.

It seems to derive from this inconsistency the fact that the Chilean courts needed to justify the decision in this case on the lack of legitimate business reason of the transactions. This is however a solution that also deserves criticism, as the Chilean tax system does not include any general principle on this regard. For sure, this is a matter of further discussion in the future.

Astrid Schudeck (astrid.schudeck@cl.pwc.com)
PwC
Tel: (+56 2) 29400155
Web: www.pwc.com/cl

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