Top tax changes in Latin America

The tax teams of foreign-owned companies in Latin American countries are confronting massive tax changes like never before. As geopolitical developments like US tax reform and the Organisation for Economic Co-operation and Development’s project to curb base erosion and profit shifting (BEPS) alter the landscape for international tax arrangements, countries in the region are making changes affecting foreign investors to domestic tax rules. And within this mix of multilateral measures and domestic reforms, foreign investors will find some new tax preferences and incentives that will continue to make the region a complex but highly tax-effective destination for their investment dollars.

In this article, we highlight some of the most important recent tax changes in key Latin American jurisdictions and their implications for investors in the region.

After 5 years of decline, foreign direct investments inflows to Latin America grew by 13.2 percent in 2018, totaling 184.287 billion US dollars (USD). The five countries gaining the largest share of these investments were Brazil (48 percent of the total), Mexico (20 percent), Argentina (6 percent), Colombia (6 percent) and Panama (4 percent).

Panama was the only country in the region to attract increasing investment during the entire last decade, rising from fifth in the ranking of FDI recipients (from ninth) between 2010 and 2018. In 2018, Panama overtook Chile in attracting inbound investment, due in part to the infrastructure projects like the Panama Canal expansion that aim to make Panama a hub for transport and logistics.

Inbound FDI has come largely from investors in Europe and the United States. European interests have a significant presence in the Southern Cone countries of Argentina, Chile, Brazil, Paraguay and Uruguay, while US investors are more focused on Mexico and Central America. Colombia and Central America are attracting significant intraregional investment.

With the US being the biggest source of FDI in the region overall, the US tax reform introduced at the end of 2017 is undoubtedly affecting investment flows in the region. In particular, the US exemption on dividends from foreign-source income may be encouraging international US-based companies to revisit holding company structures and invest in the region through the US directly.

To be tax-efficient, holding company structures still need access to tax exemptions for capital gains and reduced treaty withholding tax rates for foreign-source dividends. As a result, treaty networks and the full participation exemption available in many European countries will remain relevant for international groups in Latin America. Countries in Latin America, Europe and around the world are implementing the OECD-developed Multilateral Instrument, and how this mechanism for making synchronized changes to the treaty networks of participating countries will affect holding company structures in the region remains to be seen.

Mexico, Chile and Argentina are among the Latin American countries have signed the MLI. 

Mexico has one of the region’s largest tax treaty networks, with 61 treaties now in force and 15 more in negotiation. In signing the MLI, Mexico opted to adopt the principal purpose test, which has led to some discussion over what constitutes business substance, for example, for Spanish or Dutch holding companies used to invest in Mexico.

Mexico has also decided against adopting the MLI’s arbitration mechanisms, so tax disputes will continue to be resolved primarily through the mutual agreement procedures of Mexico’s tax treaties.

New rules enter into force on 1 January 2021 will treat foreign transparent entities, and legal figures, as opaque for Mexican tax purposes and subject them to income tax under the corresponding Income Tax Law that applies to them (i.e. as corporations, not-for-profit organizations, foreign residents or preferential tax regimes). Nevertheless, certain legal investment fund entities will not be treated as opaque under these rules because there is a tax incentive in the law in order to facilitate investments from private equity funds.

Chile also opted to apply the principal purpose test on signing the MLI. Chile’s most recently signed treaties — with Argentina, China, Japan, Italy and Uruguay — contain a principal purpose test, limitation on benefits clause, or both.

Chile plans to adopt the simplified limitation on benefits provision through bilateral negotiations with its almost 40 tax treaty partners, but whether this can be achieved is unknown. Chile’s current treaties contain a one-sided, Chile-specific clauses that denies any treaty relief from Chilean tax for withholding taxes on dividends. If these treaties are reopened for negotiation, Chile’s treaty partners would likely want similar relief. Until now, however, the Chilean government has been able to maintain its position on the basis of its current domestic tax rules.

The Chilean tax authority has issued instructions to prevent treaty shopping through the use of conduit companies. Similar to Mexico, any non-resident taxpayer claiming Chilean treaty benefits must provide a residence certificate and a sworn declaration stating that it is the income’s effective beneficiary. Even with this documentation in place, the Chilean tax authority will look for evidence of business substance before accepting treaty relief applications. 

Argentina was also among the first wave of countries to sign the MLI. However, the local law to implement the convention is still pending. Argentina’s bid to join the OECD is currently stalled due to negotiations with the US over trademark laws and Argentina’s restrictive treatment of royalties for withholding tax purposes.

Argentina has been steadily increasing the number of its agreements to exchange tax information. Currently, Argentina has entered or is negotiating or working to ratify 126 treaties for the exchange of tax information. Even though Argentina does not yet receive information from certain key jurisdictions, Argentina’s tax authorities have begun using the taxpayer data it has received to initiate aggressive taxpayer queries and other audit activity aimed at inbound investors.  

Beyond the MLI and actions to prevent treaty abuse, Latin American countries are also working to adopt other OECD BEPS measures in their domestic laws:

Mexico is taking steps to harmonize the MIL provisions with the OECD’s BEPS recommendations on hybrid mechanisms with changes to disallow payments to related parties residing abroad. Starting in 2020, payments to related parties or through a structured agreement will not be deductible when the income is subject to preferential tax regimes, although it still may be possible to deduct payments made at arm’s length value.

Any payment to related party resident in a country that taxes the related parties income at a rate below 22.5 percent would not be deductible in Mexico. This includes payments to the US that qualify at the reduced foreign-derived intangible income rate of 13.125 percent and payments in similar cases to other countries.

As of 2020, Mexico is capping the deduction of net interest (interest accrued in charge less interest accrued in favor) to 30 percent of the adjusted fiscal profit. Interest expense that cannot be deducted in a year can be deducted in the following 10 years.

Other countries, like Chile and Colombia, have been introducing BEPS measures one by one over time, creating uncertainty.

As a smaller economy, Chile’s strategy to draw attention and win influence with OECD has been to embrace BEPS measures early and completely, with little discussion or debate at home. This has led Chile to undertake its third major tax reform in the past decade, creating a difficult tax environment for foreign investors in the country. In addition to eliminating its tax-preferred investment platform, Chile has announced plans to broaden its permanent establishment concept, sharpen its focus on transfer pricing, require country-by-country tax reports, and compel large corporate taxpayers to file an annual affidavit setting out “global tax characterization” of operations.

Other significant Chilean proposals include a move to a single integrated system and simplified tax registries that would limit overall taxation to up to 35 percent, regardless of the residence of the direct foreign shareholder (versus 44.45 percent withholding tax). Chile is also looking at a more radical proposal to redefine deductible business expenses and provide more flexibility for expenses related to the taxpayers’ business purpose, whether directly or directly.

Brazil has introduced many anti-BEPS rules over the years, from controlled foreign company and thin capitalization rules, to limits on deductions for royalties. Measures aimed at low-tax jurisdictions include higher withholding tax rates on remittances to tax havens, strict rules on transferring tax domicile to tax havens, and the “preferred tax regime” concept.

Argentina introduced an important tax reform in January 2018, introducing a withholding tax on dividends and proposing to reduce the corporate income tax rate from 35 percent to 30 percent for fiscal years starting on or after 1 January 2018 until 31 December 2019, and then to 25 percent for 2020 and later tax periods. Argentina is also incorporating a definition of business substance in its local law that requires Argentinian taxpayers to prove the business substance of any foreign related parties they operate with.

Among amendments affecting permanent establishments, agents with a significant role in contract negotiations are deemed to create a permanent establishment, and that profits are to be allocated to a permanent establishment in relation to the functions performed, assets involved, and risk assumed.

Another important change subjects indirect transfers of shares to tax in Argentina at the general rate of 15 percent. These rules apply when a foreign entity sells or transfers shares or participations in another foreign entity and at least 30 percent the foreign entity’s value is derived from assets in Argentina.

As Latin American countries work to modernize their international tax systems and bring them in line with the OECD BEPS recommendations, they are making tax changes to attract more FDI to their economies.

Brazil’s three-pronged approach to tax reform

Brazil is approaching domestic tax reform on three fronts: reforming its indirect tax system, reforming its income tax system, and reducing payroll costs and boost employment. Brazil’s domestic tax system is notoriously complex, so the steps being taken to streamline it can help improve the country’s appeal for foreign investors.

Simplifying Brazil’s web of federal and state indirect taxes is expected to be politically difficult, since some of Brazil’s states stand to lose revenue as a result. The reform is therefore being approached in two phases:

• The first phase will see the country’s various federal indirect taxes replaced with a unified federal value added tax (VAT; IBS by its Portuguese acronym). Taxes to be eliminated include the social security gross revenue contributions (PIS/COFINS), excise tax (IP) and tax on financial transactions (IOF).
• In the second phase, the IBS would be extended to include existing state VAT (ICMS) and municipal service tax (ISS). However, this phase would depend on a constitutional amendment.

Although businesses in Brazil can expect their indirect tax obligations to get more complex during the transition, they will likely enjoy a much simpler, more harmonized system once the IBS is fully implemented.

On the income tax front, Brazilian reforms include decreasing the corporate income tax rate to 20 percent (from 34 percent) and bringing back the taxation of dividends (at a potential withholding tax rate of 15 or 20 percent).

Businesses may also benefit from Brazil’s measures to improve employment by cutting payroll costs. One proposal would eliminate the existing social security contribution for employers of 20 percent of gross salaries and reduce the current contribution 8—11 percent contribution rate for employees to 2 to 3 percent of employee contributions.  

Tax breaks for Mexico’s northern border region

Among Mexico’s incentives for foreign investors, a package of income tax and VAT reductions has been introduced to promote the development of the country’s northern border region. Delivered in the form of tax credits, these incentives would reduce income tax on qualifying earnings to 20 percent (from 30 percent) and VAT in the border area to an effective rate of 8 percent (from 16 percent). However, these incentives are set to expire at the end of 2020.

Argentina’s expanded tax incentives for new technologies

Argentina approved legislation in June 2019 that expands a tax incentive regime for domestic entities and professionals conducting certain activities relating to software to include activities related to robotics, medical research and investigation, and research and development (R&D)

The new law substantially enhances the current tax incentive regime, providing for:

• A 15 percent income tax rate (compared to the standard income tax rates of 30 percent for 2019 and 25 percent for 2020 and later), as long as the employer maintains a threshold number of employees
• Reduced social security contributions for registered employees.

The rules make it possible to credit foreign income taxes withheld from Argentinian source income derived from the eligible activities. This incentive takes effect on 1 January 2020 and will apply until 31 December 2029.  

With tax systems in flux as Latin American countries work to respond to the OECD BEPS project while modernizing tax systems and improving their competitiveness, the region remains rife with both opportunities and challenges for foreign investors in the region.

Tax leaders of companies with operations in Latin America can help prepare their companies to manage the impact of changing global and local tax policy by:

• Engaging directly in the OECD’s policy development work to influence solutions and ensure issues specific to their company’s business models and industry are addressed
• Engaging with governments, peer companies and industry associations to understand the effects of the OECD’s proposals and contribute to the development of consensus positions
• Engaging with their company’s senior management and strategy and business development teams to model and predict the effects of various scenarios on effective tax rates, cash flows and business models
• Keeping up with domestic tax reforms in the region to determine and manage their impact on existing tax structures
• Reviewing tax incentive programs for investments in specific activities or in specific business zones to take advantage of any opportunities that may be available.