Global Tax Alert. Costa Rica proposes farreaching. Income Tax Law

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1 24 March 2015 Global Tax Alert News from Americas Tax Center EY Americas Tax Center The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Services/Tax/Americas-Tax- Center---borderless-clientservice Costa Rica proposes farreaching reform of the Income Tax Law On 10 March 2015, the Costa Rican Tax Authorities published on their website a draft reform of the Income Tax Law (the ITL) for public comment (the Reform). Capital income and capital gains tax Capital income and capital gains of Costa Rican source would constitute a new category of income that, when realized (in cash or in kind), would be subject to a new tax of 15%. 1 There is a distinction between gains subject to the new tax and those subject to the ordinary income tax rate of 30% (on a net basis), which is vague and ambiguous. Based on the background section of the Reform, it seems that gains derived from the transfer of assets recorded in a taxpayer s balance sheet would be subject to the ordinary income tax rate of 30%. Capital income is comprised of: (i) income derived from real estate (e.g., leasing, rights of use granted to third parties); and (ii) income derived from movable assets (e.g., leasing, rights of use granted to third parties, royalties and other rights of intellectual property over intangibles, income derived from insurance contracts not subject to employment income taxation, dividends and similar distributions). Capital gains and losses are defined as variations in the value of assets owned by the taxpayer. Capital gains of nonresidents derived from the transfer of real estate situated in Costa Rica would be subject to a 3% withholding to be made by the purchaser. Provisions to be included in the regulations to the ITL would allow treating capital gains derived from corporate reorganizations (e.g., share purchases, in-kind contributions, mergers, bulk sales) as unrealized.

2 Capital income and capital gains derived from pension funds and plans, participations in investments funds contemplated by Law No. 7732, the sale of the primary residence of the taxpayer (under conditions to be defined in the regulations to the ITL), inheritances and gifts would not be subject to the capital income and capital gains tax. The taxable base for: Capital income derived from real estate would be gross income, less a standard deduction of 15% of gross income (20% for real estate investment funds) Capital income derived from movable assets would be the gross income generated Capital gains derived from transfers made for consideration would be the difference between the acquisition and transfer values Corporate income tax The tax year would follow the calendar year, i.e., from 1 January to 31 December instead of 1 October to 30 September of the following year. The standard income tax rate would be 30%. However, (i) micro and small companies registered with the Ministry of Economy, Industry and Commerce and (ii) micro, small and medium-sized companies registered with the Ministry of Agriculture would be subject to a progressive tax schedule ranging from 10% to 25%. Large cooperatives 2 would no longer be tax-exempt entities. Those classified as micro, small or medium companies or companies dedicated to the generation of electricity or entities regulated by ARESEP 3 would be the only entities exempt from income tax. The Reform would allow net operating losses to be carried forward for three years by taxpayers irrespective of their activity, and for five years for agricultural companies. Currently, the carryforward of net operating losses is limited to industrial companies (five years for losses incurred in the first five years of operations and three years for losses incurred in subsequent years) and agricultural companies (five years). Also, the Reform would allow intangibles to be amortizable for tax purposes, which is not possible under current rules. Taxable currency exchange gains and deductible currency exchange losses would be determined based on the realization method, as opposed to the accrual method. This rule is inconsistent with the accounting treatment under IFRS. The Reform would introduce thin capitalization rules with a debt-toequity ratio of 2:1. Tax-deductible interest would not exceed the amount resulting from: total amount of interest accrued in the tax period * 2(annual balance of equity/annual balance of accrued debt bearing interest). Transactions that would not be subject to these rules include: (i) loans with financial entities supervised by the local regulator known as SUGEF for its acronym in Spanish; and (ii) vendor financing between non-related parties. In addition, expenses paid to entities that are residents of tax havens or non-cooperating jurisdictions would not be deductible. However, the scope of the transactions that would be subject to this rule is unclear. To be able to take a deduction for expenses, taxpayers would bear the burden of proof to demonstrate that a given expense corresponds to a transaction actually carried out and they would be subject to the undefined criteria of the Tax Authorities. The Reform would define tax havens or non-cooperating jurisdictions as those jurisdictions: (i) where the corporate income tax rate is less than 40% of the applicable Costa Rican corporate income tax rate (i.e., currently 30%); or (ii) that do not have a tax information exchange agreement or a double taxation treaty comprising a provision for the exchange of information. The Reform would amend the permanent establishment definition for nonresidents. The new definition would not correspond entirely to the most recent definition included in the Organisation for Economic Cooperation and Development Model Tax Convention on Income and on Capital (15 July 2014 version). The Reform also would: Cap deductions for donations at 10% of the taxpayer s net income (excluding the amount of the donation) 2

3 Allow fixed assets to be revaluated and adjusted for inflation using the variation of the consumer price index published by the National Institute of Statistics and Census 4 in the corresponding tax period; the adjustment would be excluded from gross income Include an express reference to the arm s-length principle for transfer pricing purposes in the ITL Withholding tax on remittances abroad; taxation of passive income repatriated to Costa Rica The withholding tax rates applicable to payments abroad of Costa Rican-source income generally would be subject to a standard rate of 15%, instead of rates currently ranging from 5.5% to 50%. However, the following items would be subject to a 5.5% withholding tax rate: Payments for transportation and telecommunications services Insurance premiums and reinsurance payments Interest, commissions and financial expenses paid by entities supervised by the regulator of financial entities (SUGEF) to foreign entities that are also regulated and supervised in their jurisdictions 5 The Reform would maintain the territoriality of the Costa Rican tax system (i.e., whereby income is only derived within the Costa Rican territory and from Costa Rican sources), but with two significant exceptions: Income or benefits derived from services used within the Costa Rican territory would be treated as locally sourced income and hence subject to taxation at a rate of 15%, regardless of where the services are rendered. Passive income (i.e., dividends, interest income, royalties, rental income from real estate, capital gains, compensation or prize money obtained by soccer clubs or players) generated abroad and repatriated to Costa Rica would be subject to taxation at a rate of 15%. The Reform also would include a rebuttable presumption whereby any repatriation of capital that is credited to an account held in a financial entity supervised by the regulator of SUGEF, or repatriated by any other means, would be presumed to constitute passive income. Employment income taxation Employment income would be subject to two additional tax brackets with rates of 20% and 25%. The highest rate is currently 15%. The new progressive tax schedule would be as follows: Monthly Taxable Income in colons Rate Up to 793, % Exceeding 793, up to 1,190, % Exceeding 1,190, and up to 2,225, % Exceeding 2,225, and up to 4,450, % Exceeding 4,450, % Distributions of profits paid by Employer-Employee Associations 6 would be subject to employment taxation. Severance payments in excess of the maximum of eight years would be subject to a 15% tax. Endnotes 1. Note: A lower rate of 8% applies to income derived from: (i) securities issued in local currency within the framework of a public interest entity created to raise funds to solve housing problems (in Spanish: Sistema Financiero Nacional para la Vivienda); and (ii) securities issued by local savings and loans cooperatives. 2. e.g., Dos Pinos, Costa Rica s largest dairy products producer. 3. i.e., Spanish acronym for the regulator of public services in Costa Rica. 4. In Spanish: Instituto Nacional de Estadística y Censos, a.k.a. INEC. 5. Consistent with the Reform of Law No. 8634, Development Bank System Law, and amendments to other laws (In Spanish: Reforma Integral de la Ley N 8634, Ley del Sistema de Banca para el Desarrollo, y reforma de otras leyes) recently approved by the Costa Rican Congress. 6. In Spanish: Asociaciones Solidaristas. 3

4 For additional information with respect to this Alert, please contact the following: Ernst & Young, S.A., San José Rafael Sayagues Alexandre Barbellion Randall Ocquendo Juan Carlos Chavarría Antonio Ruiz Guillermo Leandro Paola Castro Diego Viquez Ernst & Young LLP, Latin American Business Center, New York Ana Mingramm Enrique Perez Grovas Pablo Wejcman Ernst & Young LLP, Latin American Business Center, London Jose Padilla

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