Global Tax Alert. Costa Rican Government submits to Congress two bills to replace the Income Tax Law and substitute the current Sales Tax Law with VAT

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1 26 August 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 Rican Government submits to Congress two bills to replace the Income Tax Law and substitute the current Sales Tax Law with VAT Executive summary On 10 August 2015, the Costa Rican Executive Branch sent to Congress two significant bills that would: (i) replace the Income Tax Law (the Income Tax Reform) and (ii) substitute the existing Sales Tax Law with a Value Added Tax Law (the VAT Law). The bills are to a large extent based on drafts submitted by the Tax Authorities earlier this year for public comment. 1 If enacted, the Income Tax Reform will increase taxes for many taxpayers (e.g., by taxing capital gains or foreign passive income repatriated to Costa Rica). The VAT Law will tax services that are currently not taxed under the Sales Tax Law. Detailed discussion Income Tax Law According to the background section of the Income Tax Reform, the Government intends to modernize the Income Tax Law that was adopted over 20 years ago to align it with international standards and the latest best practices. The key changes proposed by the Income Tax Reform include: 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 generally be subject to a new tax rate of 15%.

2 Gains derived from assets or rights connected with for-profit activities would be subject to the ordinary income tax rate of 30% (on a net basis). Corporate income tax Tax year The tax year would change from a fiscal year (1 October to 30 September) to a calendar year (1 January to 31 December). Loss carryforward Subject to certain limitations, taxpayers could carry net operating losses forward for three years, irrespective of their activity, and for five years for agricultural companies. 2 Amortization of intangibles Intangibles would be amortizable for tax purposes, which is not possible under the current rules. Currency exchange gains and losses Special rules regarding currency exchange gains and losses would be added and would require unrealized gains or losses to be reported for tax purposes at the end of the tax year. Thin capitalization rules Thin capitalization rules with a debt-to-equity ratio of 2:1 would be introduced. Transactions that would not be subject to these rules include: (i) loans with financial entities supervised by SUGEF (its acronym in Spanish), the local regulator of financial entities and (ii) vendor financing between nonrelated parties. Expenses paid to tax havens Expenses paid to entities that are residents of designated tax havens or non-cooperating jurisdictions would not be deductible. The scope of the transactions subject to this rule, however, is unclear. To deduct expenses, taxpayers would bear the burden of proving that a given expense corresponds to a transaction actually carried out and they would be subject to undefined criteria of the Tax Authorities. 3 Transfer pricing The Income Tax Reform would include an express reference to the arm s-length principle for transfer pricing purposes and a definition of related parties. Withholding tax on remittances abroad The withholding tax rates applicable to payments abroad of Costa Ricansource income generally would be subject to a standard rate of 15%, instead of rates currently ranging from 5.5% to 50%. The following items, however, 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 SUGEF to foreign entities that are also regulated and supervised in their jurisdictions A 20% withholding tax rate would also apply to payments made for: Patents, trademarks, exclusivity agreements, franchises and royalties Salaries and any other type of compensation paid for dependent personal services, fees and commissions Extended territoriality The Income Tax Reform would maintain the territoriality of the Costa Rican tax system (i.e., whereby only income derived within the Costa Rican territory and from Costa Rican sources is subject to local taxation), but with two significant exceptions: Services rendered abroad but used in Costa Rica 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 15% rate, regardless of where the services are rendered. Taxation of passive income repatriated to Costa Rica Passive income 4 generated abroad and repatriated to Costa Rica would be subject to taxation at a rate of 15%. The Income Tax Reform also would include a rebuttable presumption under which repatriation of capital that is credited to an account held in a financial entity supervised by the SUGEF, or made in whatever form, would be presumed to constitute passive income. The taxation of passive income repatriated to Costa Rica is described in the background section of the Income Tax Reform as the reinforced territoriality concept 2 Global Tax Alert Americas Tax Center

3 and is viewed as a transition step towards a scheme of worldwide income taxation. 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 VAT Law The current Sales Tax Law would be repealed and replaced by the VAT Law. According to the background section of the VAT Law, the Government intends to tax the most dynamic sector of the Costa Rican economy (i.e., the services), which is, for the most part, not affected by sales tax under the current system. Under the proposed VAT Law, services would generally be taxable, and only a certain amount of goods and services would be exempted. The key features of the VAT Law include the following: VAT would generally apply to the sale of goods and the supply of all types of services within Costa Rica, as opposed to a very limited number of services under the current sales tax system. 5 The recovery of input tax, i.e., VAT charged on goods and services supplied to the taxpayer for business purposes, would be regulated by a new set of rules. The VAT rate would gradually increase from the current 13% to 14% for the first year following the entry into force of the VAT Law, and to 15% for the second and subsequent years. A reduced rate of 5% would apply to certain items, including: (i) the purchase of packing materials, as well as raw materials used in the production of packing materials, (ii) services used in the production of agricultural or agro-industrial products or (iii) plane tickets for flights initiating in Costa Rica (domestic or international). Exemptions from VAT include: (1) certain basic foods listed in the VAT Law, (2) exported goods, (3) commissions and interest derived from loans and financings granted by entities regulated or supervised by certain local public authorities (e.g., SUGEF 6 ) or the stock market regulator, 7 (4) rental income for real estate exclusively used for housing, provided the monthly rent does not exceed a base salary, 8 (5) private education services and (6) self-consumption of electric power produced from solar panels. The transfer of all of the taxpayer s assets or one or several lines of its business by means of a corporate reorganization, a stock purchase, an in-kind contribution, a merger or a bulk sale would not be subject to VAT when the transferee continues the activities of the transferor. Global Tax Alert Americas Tax Center 3

4 Endnotes 1. See EY Global Tax Alerts, Costa Rica proposes far-reaching reform of the Income Tax Law, dated 24 March 2015, and Costa Rica proposes significant reform of General Sales Tax Law, dated 1 April 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). 3. 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. 4. Dividends, interest income, royalties, rental income from real estate, capital gains, compensation or prize money obtained by sports clubs or professional athletes domiciled in Costa Rica. 5. The supply of services rendered abroad would be subject to VAT when the recipient of those services in Costa Rica is a VAT taxpayer. 6. In Spanish: La Superintendencia General de Entidades Financieras. 7. In Spanish: La Superintendencia General de Valores. 8. Note: base salary does not refer to a minimum wage. It is a monetary point of reference updated every year by the Ministry of Finance. It is typically used in many laws as a reference to compute e.g., tax penalties. It amounts to 403, colones (approximately US$755) for Global Tax Alert Americas Tax Center

5 For additional information with respect to this Alert, please contact the following: Ernst & Young, S.A., San José Rafael Sayagues Juan Carlos Chavarria Alexandre Barbellion Randall Ocquendo 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 Global Tax Alert Americas Tax Center 5

6 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Americas Tax Center 2015 EYGM Limited. All Rights Reserved. EYG No. CM5717 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com