Given the political and economic turmoil experienced throughout Central America in the 1970s and 1980s, the turnaround of events which began in the late 1980s and early 1990s can best be described as nothing less than a miracle.
The tax systems adopted by the Central American nations during the 1950s and 1960s relied primarily on import tariffs as a source of revenue, not on income or property taxes. As free trade increased during the 1960s, especially following the implementation of the Central American Common Market, governments lost a significant share of their revenues.
Political opposition by powerful landowners prevented governments from recovering this lost revenue through enacting income and property taxes; consequently, governments tapped into the surplus of credit extended by commercial banks during the 1970s, resulting in ever-growing fiscal deficits. When the flow of loans abruptly ended in 1982, the burden of servicing these public and private debts caused a severe regional economic depression commonly referred to as the lost decade.
Impediments to investment into the region stem mainly from the relatively small size of the market, low purchasing power of the majority of inhabitants, and scarcity of local financing. The governments of the Central American nations have enacted legislation designed to:
encourage foreign investment by guaranteeing national treatment to most foreign investments,
promote exports by establishing free trade zones; and
gradually reduce trade barriers by entering into various trade agreements.
These and other types of incentives have helped to make the Central American region increasingly attractive to multinational corporations, especially those based in the US.
Trade agreements
Intra-regional trade and investment in Central America increased during the 1960s, but the region did not achieve balanced growth and development among member nations. In 1993, the Central American Common Market (CACM) was replaced with the Central American Free Trade Zone, whose members include El Salvador, Guatemala, Honduras and Nicaragua.
With the exception of certain items, mainly agricultural products, there are no import duties for products traded among member nations. In addition, a common external tariff ranging from 5% to 20% is established for most products. In 1995, member nations agreed to reduce during the next few years the common external tariff to 0%-15% for most products, but allowed each country to determine the timing of such changes.
All of the countries in the region are beneficiaries of the Caribbean Basin Initiative (CBI). This is a programme enacted by the US to encourage the economic development of designated countries in Central America and the Caribbean through unilateral and temporary duty-free trade preferences.
A country eligible for CBI benefits is one which has an agreement in effect with the US providing for the exchange of information necessary to carry out and enforce the tax laws of either country. To attain duty-free treatment, the goods must either be produced or manufactured in a beneficiary country and meet certain rules of origin, among others that the product is directly exported by the beneficiary country to the US, or at least 35% of the value added must originate in the beneficiary country.
Income tax ? principle of territoriality
The governments of the Central American nations have, for the most part, completely revamped their internal tax structure by streamlining the filing system and broadening the tax base. The tax system adopted by the Central American nations, except for Honduras, is based on the principle of territoriality, ie taxpayers are taxed exclusively on the basis of their domestic source income, irrespective of the residence, domicile, citizenship, or nationality of the recipient.
Income is deemed to be from domestic sources when services or activities giving rise to such income are rendered or conducted respectively within the national territory, or such income is derived from assets located in the country. Therefore, only to the extent that a place of business generates domestic source income will taxation in these countries apply, ie foreign source income is not taxable.
As previously mentioned, Honduras is the only country in Central America with a worldwide system of taxation. Therefore, a distinction needs to be made with respect to the taxation of income earned by domestic and foreign companies. Honduran residents, whether individuals or legal entities, are subject to tax on their worldwide income while non-residents are subject to tax only on their Honduran source income.
The distinction between residents and non-residents is not significant in the tax laws of those countries with a territorial system of taxation, as their domestic law is based for the most part on the source principle; tax is imposed only on domestic source income, irrespective of whether the beneficiary of such income is a resident. Nonetheless, the distinction can become relevant with regard to the withholding tax rates imposed on payments made to non-residents.
The concept of permanent establishment is not specifically addressed by the tax laws of these countries, with the exception of Costa Rica. Branches, agents and other permanent establishments of foreign entities are treated as separate entities for income tax purposes and taxed under the general rules that apply to resident entities. Other than in El Salvador and Nicaragua, any income that a local branch or permanent establishment credits or remits to its home office abroad will be treated as a distribution of profits or dividend respectively, and therefore subject to withholding tax.
Box 1: Business entitiesForeign investors may conduct business in Central America through a variety of legal entities. The most widely used form of business vehicle by foreign investors throughout Central America is the stock corporation (sociedad anónima), which is similar in nature to a US corporation. A brief description of the more commonly used business entities in Central America follows:
As noted above, a minimum of two shareholders is typically required to incorporate a stock corporation, except in Honduras where a minimum of five shareholders is required. In Costa Rica and Panama, shares of a stock corporation or limited liability company may eventually be owned by a single individual or corporation, even though two shareholders are initially required to establish such entities. In terms of capital structure, minimum capital requirements for establishing a stock corporation varies between countries. For instance, in Guatemala a minimum capital of Q5,000 ($800) and at least 25% of the nominal value of subscribed capital must be paid in to form a stock corporation. In Honduras a stock corporation is required to have a minimum capital of La25,000 ($2,000) and at least 25% of subscribed capital paid in at the time of formation. In sharp contrast, Panama and Costa Rica do not impose any minimum capital requirements with regard to the establishment of a stock corporation, although Costa Rica does require that at least 25% of subscribed capital is paid in. One should also be aware of the legal reserve requirements that may exist in some of these countries. In Guatemala, for instance, 5% of net earnings must be set aside annually as a legal reserve until 15% of share capital is accumulated. In Honduras, 5% of annual net profits must be allocated to a legal reserve until such reserve equals 20% of share capital. Although the legal reserve is required for accounting purposes, it does in fact reduce the amount of retained earnings that may be distributed as dividend. All of the above legal entities, with the notable exception of joint ventures, are required to register by filing certain documents with the regulatory and tax authorities. For instance, foreign entities interested in conducting business in Guatemala must register with the Mercantile Registry (Registro Mercantil) and with Guatemala's tax authority (Dirección General de Rentas Internas), Regulatory approval may not be required, or may at least be minimized, with respect to foreign companies or individuals seeking to:
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Taxable income defined
Gross income includes all income received by or accrued to a taxpayer during the fiscal year. Capital gains are for the most part taxed as regular income while capital losses can only be used to offset capital gains. Taxable income is computed by deducting ordinary and necessary expenses from gross income.
Expenses paid or accrued during the tax year are generally deductible to the extent they are necessary to generate taxable income; on the other hand, expenses incurred to generate exempt income are not deductible. Accordingly, expenses incurred that generate taxable and non-taxable income are apportioned to both types of income.
Expenses that are normally deducted by legal entities doing business in the region are as follows:
depreciation expenses representing the normal wear and tear of assets used in the taxpayer's business or activities to generate taxable income. Taxpayers are generally allowed to depreciate the value of fixed assets using the straight line method. Other depreciation methods are available such as the sum-of-years digits method in Costa Rica and Panama, and the declining balance method in El Salvador. In addition, tax authorities in Honduras and Nicaragua may grant taxpayers permission to use accelerated methods of depreciation for certain assets;
amortization expenses: intangible assets are generally amortized over their useful life. In some countries, the cost of goodwill may not be amortized;
interest paid on debt to the extent used to generate taxable income: in Nicaragua and Guatemala, interest paid to foreign-related parties is deductible to the extent the rate of interest charged is at arm's length (market rates);
royalty payments to the extent they are duly registered with the local registry and are in relation to the production of taxable income; and
all taxes paid or accrued, except income taxes which ordinarily are not deductible.
Other expenses that can be deducted against gross income to arrive at net taxable income include, among others, bad debts arising in the ordinary course of business, rents, salaries and other remuneration, charitable contributions, entertainment expenses, advertising, start-up expenses, repairs and maintenance, and social security contributions. Dividends paid or credited to a shareholder are not deductible for tax purposes.
Although there are no formal transfer pricing rules, there are certain limitations as to the amount of interest paid that can be deducted for tax purposes. For instance, in Honduras interest is not deductible if paid on a loan between a local company and its shareholder, and in Costa Rica and Guatemala where the portion of interest paid in excess of average market rates published by the Central Bank is not deductible.
None of the tax regimes in the region allows a corporate taxpayer to carry back net operating losses to offset taxable income generated in previous years. However, taxpayers are allowed to carry forward net operating losses to offset taxable income generated in future years, except in El Salvador and to a certain degree in Honduras.
The carryforward periods with respect to net operating losses are as follows: Costa Rica ? three years, Guatemala ? two years, Nicaragua ? four years, and Panama ? five years. In Honduras, taxpayers are generally not allowed to carry forward net operating losses, although certain entities in the agricultural, industrial, mining and tourism sectors are allowed to carry forward net operating losses to the three succeeding years.
Tax rates compared
Corporate income tax rates throughout the region vary between 25% and 35%. Some countries impose the tax through a flat rate while others tax income earned by corporate entities at progressive rates. Countries that levy a flat rate of tax on corporate income are El Salvador with a rate of 25% on amounts exceeding ESc75,000 ($300), and Guatemala and Nicaragua, with a rate of 30%. It should be noted that with effect from July 1 1997, the corporate income tax rate in Guatemala was reduced from 30% to 25% over a two-year period. The corporate income tax rate in Nicaragua will be lowered to 25%, beginning July 1999.
Other countries levy corporate income at progressive tax rates up to 30% in Costa Rica, 34% in Panama, and 40.25% (35% corporate income tax rate plus a 15% surcharge on amounts over La1 million) in Honduras. See Box 3, for details of withholding tax rates on payments made to corporate non-residents with respect to dividends, interest, royalties and branch remittances.
Capital gains are generally treated as ordinary income and subject to regular income tax rates, except in Guatemala and Honduras where capital gains are taxed at a reduced rate of 10%, and in Costa Rica where capital gains are not subject to tax. The highest marginal tax rates in the region for individuals varies from 25% in Costa Rica and Guatemala; 30% in El Salvador, Nicaragua and Panama; and 40% in Honduras. Pursuant to a tax law enacted in 1997, the maximum marginal rate in Nicaragua for individuals will be reduced to 25% as of July 1999. Taxes paid abroad may not be used by either corporations or individuals as a tax credit against income tax payable.
Fiscal year and consolidation
For income tax purposes, the annual tax period is normally the calendar year, with the exception of Guatemala and Nicaragua where the tax period runs from July 1 to June 30, and Costa Rica, where the fiscal period starts October 1 and ends September 30. There are no formal thin capitalization rules (debt-to-equity ratios) in any of the tax regimes of the Central American nations, although the assets tax (discussed below) provides a means to monitor thin capitalization.
In addition, none of the tax regimes allows affiliated companies to file consolidated tax returns. Contrary to other countries in Latin America the domestic laws of the Central American nations do not, with the exception of Costa Rica, require taxpayers to make adjustments to their taxable income to take into account the effects that inflation may have on taxation.
Box 2: Value-added taxAccording to the World Bank, the amount of revenues reported by the Central American tax authorities between 1990 and 1995 through the imposition of value-added tax (VAT) ranged between 5% and 40% of all tax revenues. Unlike tax on income, VAT taxes consumption rather than savings, permits a full exemption on exports through rebates, and tends to be easier to administer than income tax. The tax is computed under the subtraction method by crediting VAT paid on purchases and services (input VAT) against the VAT charged on sales and services (output VAT). This mechanism ensures that only the value added by the taxpayer will be subject to VAT. Moreover, to the extent VAT paid exceeds VAT collected, such credit balance may generally be carried forward to offset future VAT collected, with the exception of Panama. In some countries an application for reimbursement of excess VAT credits may be requested from the tax authorities. In Guatemala qualified exporters that are duly registered with the local tax administration may seek a refund for excess VAT paid. Furthermore, an application for reimbursement can be requested for excess VAT paid in Honduras; however, in practice it takes a very long time to obtain the actual funds. The general rates of VAT levied throughout the region are as follows: Costa Rica ? 13%; El Salvador ? 13%; Guatemala ? 10%; Honduras ? 7% on most goods, 10% on alcoholic beverages and tobacco products; Nicaragua ? 15%; and Panama ? 5% on most goods, 10% on alcoholic beverages and tobacco products. In Honduras and Panama, there is no VAT as such. Instead, there is a sales tax which operates as a value-added tax; the amount of sales tax paid by the company is to be recovered from sales tax collected on goods sold and/or services provided to its customers. Taxpayers must register with the tax administration once they are deemed to be a VAT taxpayer. They are also required to issue invoices (facturas) or credit vouchers for their sales and services, in which the following information is noted: registration number, sales price, amount of tax due, and other data. Value-added tax returns are generally filed on a monthly basis. |
Box 3: Withholding tax on payments to non-resident corporations
(a) For the fiscal period July 1 1997 through to June 30 1998, the withholding tax rate in Guatemala will be 30%; for the fiscal period July 1 1998 through to June 30 1999 the withholding tax rate will be 27.5%; and for fiscal periods starting July 1 1999 the withholding tax rate will be 25%. (b) Effective tax rate of 22.5% results from applying 30% income tax rate to a 75% presumed net interest income. (c) Effective tax rate of 28.5% results from applying 30% income tax rate to a 95% presumed net royalty income. |
Assets tax
Many of the jurisdictions throughout Latin America have enacted a tax on assets which serves mainly as an alternative minimum tax to the income tax imposed on companies doing business in the region. In most instances, the tax on assets applies to resident companies, and branches and other permanent establishments of non-resident taxpayers, not to individuals. The assets tax is applied either on a gross or a net basis, and is payable in any given tax year only where it exceeds income tax liability.
Gross assets are generally defined as the total assets shown on the balance sheet at the end of the fiscal period, less an allowance for doubtful accounts receivable and accumulated depreciation and amortization. Net assets result from the difference between assets and certain liabilities.
An annual assets tax of 1% is imposed in Costa Rica and Honduras on companies with respect to their gross assets located in the country, while the annual tax on assets is payable on a quarterly basis at a rate of 1.5% of gross assets in Guatemala. Taxpayers with assets below a certain threshold are exempt altogether from tax in Costa Rica and Honduras. Specifically, companies with assets not exceeding CRc30 million ($120,000) at the end of the fiscal year are exempt from tax in Costa Rica, whereas companies with assets not exceeding La750,000 and maquiladoras that export all their products outside Central America are exempt from tax in Honduras.
The creditability of any taxes paid by a subsidiary of a US multinational under section 901 of the Internal Revenue Code will depend on whether income tax paid by the subsidiary can be used as a tax credit against its assets tax liability. The interaction of the income tax and the assets tax was specifically addressed by the US Internal Revenue Service in Revenue Ruling 91-45. This considered the impact of the so-called multiple levies rule to determine the credibility of the Mexican income tax paid or accrued for US foreign tax credit purposes.
In countries such as Costa Rica and Guatemala, assets tax paid can be used as a tax credit to offset the taxpayer's income tax liability. Therefore, the amount of assets tax credited against income tax liability will not constitute a creditable tax for US purposes. On the other hand, in Honduras where income tax paid can be used to offset the tax on assets, all of the income tax paid or accrued by a local corporation may be used as a foreign tax credit by a US parent.
In practical terms, taxpayers will not be able to obtain a reimbursement from the local tax administration with regard to the amount of excess assets tax paid in any given fiscal year. Finally, it should be noted that although no tax is levied on assets in El Salvador at the national level, various municipalities throughout the country do impose a tax of up to 1% of net tangible assets. Furthermore, no tax on assets is levied in either Nicaragua or Panama.
Import duties
Imports are generally subject to tariffs assessed on an ad valorem basis, ie import duties are calculated applying the relevant rate to the cost, insurance and freight (CIF) value of the imported good. Imports from outside the Central American region are typically subject to tariffs ranging between 5% and 20% ad valorem on CIF value, except for items covered by special incentives or purchased directly by government agencies.
Nicaragua, which reduced its import duties from rates as high as 350% in the 1980s, maintains a tariff (derechos arancelarios a la importación) on virtually all imports that ranges from 5% to 20% of CIF value. Panama's nominal tariff duties remain the highest in region with an average 40% in tariff rates.
Within the framework of the CACM, member countries continue to pursue the goal of liberalizing trade and lowering tariffs. Accordingly, member countries have agreed gradually to reduce tariff rates for raw materials and inputs produced outside Central America. Honduras, for example, agreed to reduce tariff rates for raw materials produced outside Central America from 5% to 3% as of May 1 1997, and to 1% as of December 1 1997. On April 1 1995, El Salvador lowered its import tariff on capital goods from 5% to 1%, while a further reduction in January 1997 cut the tariffs on most capital goods, intermediate goods and raw materials to zero. Furthermore, duties on imported raw materials, bulk grains and oilseeds were reduced from 5% to 1% in Costa Rica, effective July 1 1996.
Although most products are subject to import tariffs ranging between 5% and 20% of CIF value, certain commodities of substantial local interest may be protected with significantly higher tariffs. Honduras protects locally produced items such as grains, poultry, leather and textiles with tariffs that range up to 100%.
Social security contributions
No limits are generally imposed on the amount of earnings subject to social security taxes, other than in certain countries such as Honduras where the maximum amount of wages and salaries subject to social security is La600 per employee a month. |
An additional temporary protection tariff (arancel temporal de protección) of 5% to 10% of CIF value is levied in Nicaragua on 900 imported items, largely goods also produced locally. These duties are to be gradually lowered and eliminated by the year 2000. Finally, in addition to tariff barriers, the various Central American nations have eliminated most non-tariff barriers to trade, including import licensing requirements and import quotas.
Other taxes
In addition to the tax on income, assets and value added, there are other taxes that foreign investors should be aware of. The specific taxes implemented in each of the countries may vary, but the more relevant ones described below are stamp tax, excise tax, and social security taxes.
The stamp tax (impuesto de timbre) is a tax on the value of certain transactions that require documentation. Transactions that are typically subject to stamp duties include all types of civil and commercial contracts such as promissory notes and loan agreements, and real estate transactions involving deeds, mortgages or leases. Transactions subject to VAT may not be subject to stamp duties, as is the case in Guatemala or Panama. The rates usually vary between 1% and 3% of the value of the transaction documented.
Excise taxes are levied on the value of certain goods imported into the country, such as alcoholic beverages, cigarettes, tobacco and gasoline. The rates vary greatly between countries: Costa Rica for instance, imposes very high rates of excise tax ranging anywhere between 5% and 75%, while the general excise duty in Honduras is set at a rate of 10%.
Social security is financed mainly through contributions made by employers and their employees, and in certain cases, by the local government. In addition to paying their own contributions, employers must withhold and remit to the government the contributions of their employees. All contributions are computed on the basis of the salaries and wages earned by the employees. The contributions in the box above are to be made in each of the countries in the region.
Tax treaties
As tax is imposed on domestic source income (with the exception of Honduras), there is little risk of double taxation for foreign entities doing business in Central America. Taxation of outbound investments made by foreign entities in the region is wholly governed by domestic law. This explains, in part, why none of the Central American nations has yet concluded any treaties for the avoidance of double taxation with a third country.
Costa Rica has, nonetheless, signed treaties for the avoidance of double taxation with the Federal Republic of Germany and Romania on January 25 1993, and July 12 1991, respectively. Neither of these tax treaties has entered into force as of the date of publication of this article. Negotiations for an income tax treaty are underway between Nicaragua and Mexico.
It should be noted that the first income tax treaty concluded by the US with a Latin American nation was an income tax treaty for the avoidance of double taxation signed on June 25 1956 between the US and Honduras and entered into force in 1957. Unfortunately the US-Honduras income tax treaty was terminated with effect from December 31 1966. For the foreseeable future, it is unlikely that the US will conclude income tax treaties with any of the nations of Central America. The US Treasury Department has indicated that its first priority is to negotiate and conclude tax treaties with some of the larger countries in South America, especially Brazil and Argentina where there are significant US investments.
Despite the absence of tax treaties for the avoidance of double taxation, some of the nations of Central America have concluded other types of tax treaties with the US. For instance, the US signed Tax Information Exchange Agreements with both Costa Rica and Honduras, which entered into force on February 12 1991, and October 11 1991, respectively. In addition, with effect from 1987 the US entered into transportation agreements with Panama and El Salvador, in relation to the taxation of income derived from international transportation operations.
Planning techniques
US multinationals with operations in Central America can take advantage of several tax planning techniques to reduce their overall tax liability and fulfill their business needs. Some of these techniques are outlined below.
Caribbean Basin Initiative
Foreign investors who operate in free trade zones located throughout Central America are entitled to special tax privileges, which for the most part consist of an exemption from income tax and duty-free import of raw materials and equipment necessary to produce or manufacture goods for export. The low cost of manual labour and rentals contributes to the massive presence of companies in such free trade zones, especially those involved in apparel assembly. Nonetheless, there is growing interest in attracting other types of light industry, such as automotive parts, electronic components, machinery, sporting and consumer goods, telecommunications equipment, and data processing services.
The CBI sets forth reduced tariffs on many products manufactured in beneficiary countries and imported into the US. Those industries that produce CBI-eligible goods tend to be labour intensive requiring medium- to high-skilled workers.
Many of the products mentioned previously are eligible for duty-free treatment into the US, yet would not be competitive if imported from outside the Caribbean as they would be subject to relatively high US duties. As an example, many of the electronic components and telecommunications equipment now being manufactured or assembled in Costa Rica would be eligible for favourable customs treatment under the CBI programme.
Foreign sales corporations
US exporters that sell abroad through a foreign sales corporation can save an estimated 15% to 30% of US income tax attributable to export sales, resulting in a reduction of effective US tax of up to five percentage points. A foreign sales corporation can operate on either a buy/sell or commission basis; the vast majority of foreign sales corporations are commission foreign sales corporations, which do not take legal possession of the property but instead receive a fee for facilitating export sales. As exports sales are made, the US parent pays the foreign sales corporation a commission as determined under one of three transfer pricing methods. The foreign sales corporation pays US tax on a portion of the commission income, and afterwards may distribute dividends back to the US parent without any further US tax consequences.
The foreign sales corporation status requires a corporation to be organized in a qualifying US possession or an eligible foreign country.
Although most foreign sales corporations are incorporated in the US Virgin Islands or Barbados, foreign sales corporations can also be incorporated in Costa Rica and Honduras, as these two nations are CBI beneficiary nations who have signed tax information exchange agreements with the US. Furthermore, to the extent the activities or services by the foreign sales corporation are deemed to be conducted or rendered abroad, the foreign sales corporation should not be subject to tax in Costa Rica on the commission income received from its US parent.
US final check-the-box regulations
As noted above, a minimum of two shareholders is necessary to incorporate a legal entity in Central America, including the stock corporation (sociedad anónima) or the limited liability company (sociedad de responsabilidad limitada). All stock corporations incorporated in Central America are identified as per se corporations under the final US check-the-box regulations issued on December 17 1996, and consequently are not allowed to elect non-corporate status for US tax purposes.
The limited liability company, on the other hand, is a foreign eligible entity with at least two shareholders which may elect to be treated as a corporation or as a partnership from a US tax perspective. Members of a limited liability company may also elect branch status by means of director qualifying shares or nominee shares, while satisfying local corporate law requiring at least two shareholders.
A notable exception to the two shareholder rule is a limited liability company incorporated in Costa Rica or Panama, whose shares may be owned by a single individual or corporation and, therefore, can elect branch status for US tax purposes.
The check-the-box regulations facilitate the use of the so-called hybrid entity, an entity which a foreign jurisdiction treats as a corporation, and the US treats as a partnership or branch. Several tax planning objectives can be achieved from a US tax perspective, such as obtaining a current US benefit for foreign losses, minimizing or avoiding subpart F income, maximizing use of foreign tax credits, and deferring US taxation on distribution from foreign earnings.
