Chile government introduces significant changes to tax reform package

 By Francisco Sepúlveda, RGS Abogados, Santiago de Chile

On 3 July Chile’s President and the Minister of Finance issued a set of modifications to the tax reform package that is currently being discussed in Congress. As reported earlier, on 23 August 2018 Chile’s government had delivered to Congress the main features of a proposed comprehensive tax reform.

While the original version of this reform package sought to reestablish full corporate integration, restrict the application of anti-abuse rules, and provide corporations with greater opportunities to deduct business expenses, after a year of negotiations the scope of the rules proposed has been significantly reduced.

It was expected that these modifications would occur in 2019, therefore affecting tax returns lodged April 2020.

However, everything seems to indicate that the law will not be passed before the end of 2019, thus moving its effects to early 2021, when the first tax returns must be lodged under the new system.

New rules for profit distributions

The changes include a new set of rules applicable to profit distributions that are not proportional to the shareholder’s participation in a given company if the shareholders are individuals and also related parties.

While under current rules the distribution of a company’s profits should follow its capital structure, it is a very common tax planning strategy that profits are assigned each year to the partner having the lower income, in some occasions even triggering tax refunds.

The previous tax reform (2014) introduced mechanisms to restrict this; however, no penalties were assigned.

Under the new proposed rule, not only must the attribution of a company’s profits be equivalent to the percentage of shares held, but a 35% tax is added to the portion of profits distributed in excess of capital participation.

Yet, taxpayers are allowed to justify a profit distribution proportion that is different to capital participation if there are commercial, administrative, or financial reasons which justify such alternative profit allocation.

Corporate reorganization disclosure

The changes proposed also include a rule forcing taxpayers to inform corporate reorganization processes and to deliver detailed information to the IRS.

This is in line with the later changes to the transfer pricing compliance regulations, which include detailed information regarding the corporate reorganization processes.

The PYME clause for medium and small companies

One of the main purposes of the package sent to Congress in August 2018 was to create incentives and at the same time to eliminate restrictions on trade and investment.

By that time, it was decided that the situation of small and medium companies (generically called PYME) should be strengthened.

Accordingly, in addition to the rules originally proposed, the provisions  introduced include the option of keeping simplified accounting records (income minus expenses), automatic and immediate depreciation of assets acquired for the company’s activities, an optional tax-transparent regime which would allow direct taxation in the hands of the partners, amongst other relevant features.

Tax incentives for marketing and internet activities

Although present in the current version of the Income Tax Law, the proposed changes seek to clarify the existence of withholding tax incentives for certain payments made to non-resident taxpayers in the case of marketing services and for the use of platforms in the technology industry.

Restrictions to stock market exemptions

The current regime of article 107 of the Income Tax Law provides a full exemption for any capital gains obtained for the sale of publicly traded shares in the stock market.

The requirements to access this exemption include the necessity to demonstrate that the relevant shares have had significant “stock market presence”.

While the main factor for market presence refers to the number of transactions in the period prior to their sale, separate market maker regulations grant stock market presence to shares depending on the institution in charge of their trading.

The proposed rules introduce significant restrictions to the definition of stock market presence in an attempt to reduce the use of the exemption, which has been said to create incentives for aggressive tax planning structures.

Deductible expense

One of the main purposes behind the tax reform package sent to Congress in 2018 was to modify the current definition of deductible expense in article 31 of the Income Tax Law.

Currently, for an expense to be deductible, several requirements must be met: the expense must be mandatory, inevitable, and absolutely intertwined with the activities of the company (thereby creating a series of problems in the case of auxiliary activities, environmental mitigation measures, amongst others); it must be necessary for the generation of the company’s income (which is a requirement that has created significant amount of litigation regarding assessments by the IRS, because the definition of what is necessary is precisely left to the IRS); and, more generically, the deduction of expenses is generally disallowed if the respective company is not generating any income against which they may be imputed (thus creating many problems for starting companies and loss-making position entities).

The new rules seek to introduce a new and broader definition of deductible expense, which includes new criteria for its acceptance, such as the level of connection with the interest, development, or survival of the company’s activities; the generation of present or future income; amongst other relevant factors.

Simplified foreign tax credit deduction process

Generally speaking, Chile provides for a foreign tax credit applicable against individual and corporate income tax in Chile when the income of a Chilean taxpayer has been subject to withholding taxes abroad.

 Such credits may be deducted from the respective tax determined and included in the income tax return, which needs to be lodged in April each year.

While the law in principle is broad enough to establish that these taxes may be used against Chilean tax liability, the administrative requirements to successfully use those credits is quite complicated. Assessments by the IRS usually result in the denial of such credits, thus creating a disadvantage for Chilean taxpayers investing or carrying on businesses abroad.

The changes proposed to the tax reform package include a simplified system of foreign tax credit deduction, which is mainly built upon the broadening of the means to demonstrate the actual payment of taxes in other countries as a requirement for the availability of said tax credits in Chile.

Restrictions on back-to-back structures

Another area in which the proposed reform package has sought to introduce restrictions is in the use of reduced withholding tax rates for interest remittances abroad.

While the general withholding tax rate on interest is 35%, banks and financial institutions abroad are only subject to a 4% rate. This of course incentives structures where an entity of that nature may participate as an intermediary, lending the money of the parent company to its Chilean subsidiary, for instance, thus allowing the former to access lower rates of withholding tax.

By following a definition that is similar to the beneficial owner definition in tax treaties, the new rule seeks to restrict back-to-back structures by pointing in the direction of the bank or financial institution lending the money. If such institution only operates as an intermediary, the lower rates of withholding tax will not be applicable.

Digital services

Another main feature of the tax reform package of 2018 was the creation of a new tax statute for the digital industry.

Under current law, digital services rendered from abroad to Chilean users are not necessarily free of taxes. Withholding tax regulations may cover the case of these operations, but their assessment is highly complex and avoidance is relatively simple.

Thus, the changes proposed to the original bill include the introduction of new Chilean source rules applicable to digital services, such as the location of the IP using the services, the location of the credit or debit card or the bank account with which said services were paid, amongst other relevant factors.

Furthermore, there are new rules proposed dealing the taxation of digital entertainment services such as videos, music, video games, amongst others, either through streaming or by download.

Finally, further regulations have been proposed to regulate the previously announced indirect tax on digital services rendered to individuals in Chile.

Mandatory contribution rules for companies operating in regions

Bearing in mind the existence of large industries in geographically isolated areas of the country, a debate was held regarding the necessity that part of the taxes paid by those companies remain in those regions, to promote their development.

Accordingly, the changes proposed include a new regime, under which an amount equivalent to 1% of the capital investment incurred by those companies will be assigned directly to the region in which the company operates.

Digital transformation of the Chilean IRS

During the last few years, the Chilean Internal Revenue Service has been subject to a very intense digitalization process.

Electronic invoicing has been followed by the lodging of tax return almost exclusively online, and the IRS is even carrying out tax assessments in an electronic manner.

The proposed amendments seek to move forward with the full digitalization of the IRS and its internal processes.