Argentina Tax Controversy Surrounds Corporate Bonds in Argentina By Daniel Caracciolo and Pablo Tonina Buenos Aires Argentine

capital markets, already bruised from the country's record 2001 default on foreign debt and subsequent 2002 peso devaluation, face new dangers as the Argentine tax authorities launch an attack on the tax benefits of one of the country's most popular securitiespublicly traded corporate bonds (referred to as obligaciones negociables or “ON”). Background In 1988, the Argentine Congress authorized stock corporations, cooperatives and civil associations to contract debts by issuing ONs. This development was followed in 1991 with relaxed provisions and tax benefits granted if certain conditions were met. The legislative amendment and an influx of capital from abroad made ONs the most popular financial instrument in the Argentine capital markets in the 1990swith ON issuance programs exceeding $60 billion. The main tax benefits granted by the legislation include the following: An exemption from Argentine income tax on interest and capital adjustments if the beneficiary is a foreign resident or, in general, an Argentine resident that is not a corporation; · An exemption from income tax on income derived from the purchase, exchange, barter, conversion or divestiture of ONs if the beneficiary is a non-resident or, in general, an Argentine non-corporate resident; and · An exemption from value added tax (VAT) on financial transactions and services related to the issuance, subscription, placement, transfer and settlement of ONs and their guarantees. The income tax exemptions are available even when the Argentine-source income obtained by the beneficiary is taxed in the beneficiary's country of residence. However, the issuer must meet the following requirements: · · The ON must be placed by a public offering that has been approved by the National Securities Commission (Comisión Nacional de Valores, or “CNV,” a self-regulating entity providing oversight to the securities markets). The issuer must guarantee the use of funds to be obtained by means of the ON placements for: investments in fixed assets located in the country; paying in working capital in the country or refinancing liabilities; or capital contributions to companies controlled or related to the issuing company whose proceeds are exclusively used for the above-mentioned purposes. The use to be made of the funds must be specified in the resolution establishing the issuance and must be made known to the public in the prospectus. The issuer must demonstrate to the CNV, in accordance with conditions established by the CNV, that the funds obtained were invested according to the approved plan. If the issuer is a local financial entity, it may use the funds obtained from the placement to grant loans to borrowers, who must use the funds for one of the above purposes. The burden of proof regarding the appropriate use of the funds resides with the financial institution. Failure to comply will result in the issuing company forfeiting the benefits granted by the law and becoming liable for payment of taxes that the investor may have been liable for as well as , Any applicable penalty. ·

· ·

Although enforcement of the system has been relatively uneventful under the CNV's stringent supervision with respect to issuance and compliance, the Argentine tax authorities recently began challenging taxpayers' compliance with the conditions to receive the tax benefits.

Issues raised by tax authorities The technical counsel department of the Argentine Tax Bureau stated in a public, but non-binding, opinion (Opinion 16/2002) that an ON will not be eligible for tax benefits if the issuer (despite receiving CNV authorization of the issue) has not complied with the use requirements but, instead, has used the device to directly refinance debt to foreign creditors (as opposed to a permissible true public offering of corporate debt). Non-compliance can result in the issuer paying up to a 53% withholding tax on interest and a 21% VAT tax on interest. Payment of such taxes would be in addition to possible sanctions. The tax authorities further added in the opinion that issuance authorization from the CNV by itself does not fulfill the public offering requirement. The CNV procedures still must be carried out as, in principle, they grant public access to the bond offering. Compliance in this respect is a factual determination, the merits of which should be evaluated by an administrative judge. The tax authorities based their position on Argentina's substance-over-form principles (defined in Law No. 11,683 on Tax Procedures, sections 1 and 2). The basic premise of the tax authorities' arguments would seem to be a general presumption of non-compliance if there is a firm commitment of an underwriter or if the placement device provided by Rule 144A of the US Securities and Exchange Commission (i.e. a private placement device with the offering made to large institutional purchasers) is used. (The Rule 144A placement device is discussed in further detail, below.) The tax authorities seem to be declaring the need for the ON issuer to prove, beyond the involvement of and approval by the CNV the existence of a placement of ONs for public offering. , In Argentina, the concept of a “public offering” is defined (Law No 17,811), but no guidance has been issued that limits it or conditions it with respect to eligibility for tax benefits provided to ONs. Law No 17,811 regulates, among other things, the operation of the CNV, stock exchanges or markets, stockbrokers and the public offering of securities. Section 16 defines public offering in the following terms: an invitation made to persons in general or in sectors, or certain groups to carry out any type of legal act with securities, carried out by the issuer or by a sole proprietorship or company exclusively or partially engaged in trading such securities, by means of personal offerings, newspaper publications, telephone communications or television, movie theatre footage, posters, signs or billboards, etc. The tax authorities' apparent dismissal of the CNV's role as an enforcement and supervisory agency in determining compliance with the tax benefit requirements for ONschoosing instead to have the decision reached by an administrative judge (within the tax agency)is puzzling. Law No. 23,576, section 41 specifically provides that the CNV acts as the information agent to the tax authorities as regards the enforcement of this lawa provision that arguably reaffirms the CNV's role as an enforcement agency. Further the publication of a public prospectus required by the , CNV and offerings to potential investors via so-called “road shows” would not be recognized as enough evidence of a public offering. The initial opinion by the tax authorities that there is no public offering where there is a firm commitment of an underwriter, would have to be abandoned if the underwriter was able to demonstrate that acts had been carried out that make it possible to regard the placement as a public offering. Rule 144A Placement Given the influx of external capital into Argentina during the 1990s, together with the creation of ONs as financing instruments, many issuances were offered on international markets and in the US under Rule 144A. Rule 144A is an exception from the registration requirements of section 5 of the (US) Securities Act of 1933 Act for re-sales of certain restricted securities to “qualified institutional buyers” (QIBs).

Specifically, Rule 144A affords safe harbor treatment for re-offers or re-sales to QIBsby persons other than issuersof securities of domestic and foreign issuers that are not listed on a US securities exchange. Rule 144A placement devices have been widely used by issuers of international securities on US markets. In general terms, the class of QIBs includes: An institution (e.g. an insurance company, pension fund or investment company) that owns or invests at least USD 100 million in the securities of non-affiliates; and A broker or a dealer registered under the (US) Securities Exchange Act that owns or invests at least $10 million in the securities of non-affiliates. The use of this placement device requires the issuance of a prospectus providing detailed information on the issuer and the conditions of the instrument offered. It is important to note that, among the placement devices allowed, the Securities and Exchange Commission has approved establishing a website on which live road shows for Rule 144A offerings may be displayed electronically to QIBs. The tax authorities' argument regarding Rule 144A placements hinges on the interpretation that, as long as placement acts made by underwriters are carried on outside Argentina, the evaluation of compliance with the public offering requirement should be made in accordance with the relevant legislation in the place of placement (for Rule 144A, the US) and not under Argentine law. For ONs placed under Rule 144A, this presents an obvious and fundamental problemUS law considers such offers to be a private offer. Consequently, the Argentine tax authorities consider the tax benefits granted to ONs forfeited. The tax authorities have reached this conclusion despite the fact that, at no time, has Argentine legislation conditioned the grant of tax benefits on compliance with public offering requirements in third countries. Of further note is the fact that the concept of a public offering under Argentine legislation is based on different parameters than those under US legislation, making it more perplexing that an offer made to qualified investors in Argentina under a Rule 144A placement device should not be per se excluded from the concept of a public offering as defined by Law No. 17,811. The Future of ONs The tax authorities' challenges of issuers of ONs contravene, in many cases, the legality and fairness principles of government acts and they jeopardize the development of current and future capital markets. The courts should reject the tax authorities' claims if acts that qualified under Argentine legislation as public offering acts, with the authorization and under the supervision of the CNV, have been carried out. This position follows from the absence of legislation conditioning the grant of such tax benefits on compliance with other requirements (imposed by the tax authorities) that essentially redefine the concept of a “public offering” for tax purposes. The uncertainty created by the tax authorities comes at an inopportune time. The 2001/2002 default and devaluation resulted in many restructuring transactions, and Argentina is witnessing an incipient return of potential issuers of instruments for public offerings. Failure to quickly resolve this uncertainty presents a definite roadblock to the development of capital markets in Argentina and further limits the financing options of local companies.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

BRAZIL Taxation of capital gains earned by foreigners in Brazil controversial article 26 of Law No. 10,833/03
By João A. Branco Sao Paolo Law No. 10,833/03, enacted December 29, 2003, provides that a Brazilian purchaser, whether an individual or a legal entity, is responsible for withholding and remitting capital gains tax due by a non-resident seller of property in Brazil. Application of the law gives rise to an anomalous result because it also provides that if the buyer and seller are both non-residents, the purchaser's Brazilian attorney is responsible for withholding the capital gains tax due in Brazil and remitting it to the tax authorities. Article 26 reads as follows: “The acquirer, individual or legal entity resident or domiciled in Brazil, or the acquirer's attorney, when such acquirer is resident or domiciled abroad, shall be responsible for the retention and payment of the income tax applicable to capital gains under art. 18 of Law no. 9,249, dated December 26, 1995, earned by individuals or legal entities resident or domiciled abroad, who disposes of property located in Brazil.”

The intent of the legislation apparently is to impose a liability to taxation on potential capital gains derived from the sale of assets located in Brazil, even when the sale is carried out abroad.

The taxation of capital gains earned by foreign entities and individuals is governed by article 18 of Law No. 9,249/95, and these rules use the same concepts that apply for the taxation of Brazilian individuals. In simple terms, the rules define capital gains as the difference between the 'sale price' and the 'tax basis,' which corresponds to the sum of investments and reinvestments made by the foreign quota holder, in local currency, monetarily restated as from the date of the investment/reinvestment up to 31 December 1995.1 Subsequently, the applicable regulations also allow taxpayers that do not meet the above requirement to use, as a tax basis for the purpose of calculating capital gains, the amounts duly registered with the Brazilian Central Bank, through the mechanism commonly known as 'RDE-IED.'2 If the taxpayer is unable to determine the tax basis through either of these procedures, the full amount of the 'sale price' will be deemed to be 'capital gain.'

Before 1996, only Brazilian resident individuals were technically subject to income tax (“IRPF”) on earnings arising from sources of whatever nature. Prior to the introduction of Law No. 9.249/95, Brazilian legal entities were subject to income tax only on profits produced within Brazil (i.e. Brazil used the territorial system of taxation), whereas the above law introduced the worldwide system of taxation for such Brazilian entities, as amended by Law No. 9.532/97. The taxation of non-resident individuals or entities is governed by the Income Tax Regulation, dated March 26, 1999 ((“ITR/99”) enacted by Decree No. 3,000). Brazil's taxing authority over non-Brazilian residents appears in various sections of ITR/99, although most rules are found in Book III, “Withholding Taxation and Taxation of Financial Operations,” Title I, “Withholding Taxation,” Chapter V, which regulates the withholding of tax (“IRRF”) on income earned by nonresidents. These sections basically identify the non-Brazilian resident as the technical taxpayer of Brazilian withholding taxes, as quoted below:

“Art. 682. There shall be subject to withholding tax, in accordance with the dispositions of this Chapter, the income and proceeds of whatever nature obtained from sources situated in the Country, when earned: I by an individual or legal person that is resident or domiciled abroad (Decree-Law 5.844 of 1943, Art. 97, (a)). (…)” “Subsection I, Incidence: Art. 685. Income, capital gains, and other proceeds paid, credited, delivered, employed or remitted, from a source located within the Country, to an individual or legal entity resident abroad shall be subject to withholding taxation at source.

Article 685, caput contains the hypothesis of incidence of this withholding tax and Item I sets a 15% withholding tax rate for capital gains derived from Brazilian sources by non-residents. It should be clear from the above translation that ITR/99 had already incorporated article 18 of Law No. 9.249/95, particularly under §§1 and 3, which provide non-discriminatory rules for calculating the capital gains tax base and for applying the capital gains tax rate to both residents and nonresidents. Assuming that article 26 does, in fact, impose Brazilian taxation on a transaction carried out abroad between two foreign parties, the result is incongruous for the following reasons:

§

Article 26, when making a reference to article 18 of Law No. 9,249/95, implicitly defines capital gains as the difference between “sale price” and the 'local tax basis,' amounts that might not be known to the attorney of the seller. Moreover, if the investment belongs to a foreign resident, there should not be a Brazilian tax basis available for computation of this “deemed capital gain;” Article 26 expressly provides that the “the acquiror's attorney, when such acquirer is resident or domiciled abroad, shall be responsible for the retention and payment of the income tax applicable to capital gains.” The word “retention” definitely encompasses the understanding that the attorney, at a given time, would be in possession of the sales proceeds such that he/she would be able to withhold the applicable 'capital gains tax,' and subsequently remit the relevant amount to the Brazilian tax authorities. This obviously is not possible, because the attorney would be only representing the foreign seller for purposes of executing the necessary legal documents on its behalf, and as the transaction was completed abroad, no flow of funds would take place in Brazil; Since no funds would flow through Brazil, the local tax authorities would not be able to determine the amount of tax possibly due under the legislation; Finally, article 26, standing alone, would not be able to impose taxation on entities and individuals that, as foreign residents, do not qualify as taxpayers in Brazil; this would be the case even taking into account that recent regulations require such persons to obtain a 'Tax ID ' in Brazil.3 Implementation of article 26 would necessitate much more complex and comprehensive regulations, eventually bringing the provisions of an applicable tax treaty into play, as the foreign jurisdiction where seller is domiciled also would likely impose tax on the transaction.

§

§ §

Conclusion Based on the above, it is our position that article 26 is not able to create a tax liability for transactions carried out in foreign jurisdictions. The powers of the Brazilian tax authorities do not extend this far, considering the prevailing worldwide income principle (applicable to domestic taxpayers with respect to corporate income taxes) and the source of income principles (applicable to foreign taxpayers that receive income from Brazilian sources for withholding tax purposes). Article 26 would give rise to a third principle that would be akin to an 'asset territoriality' basis, not provided for in the Brazilian Tax Code. For all of these reasons, we believe that article 26 likely will be subject to challenges in the Brazilian courts should the Brazilian tax authorities seek full enforcement.

1 The Brazilian monetary restatement system was abolished as from January 1, 1996. 2 The electronic/online registration system available at the Central Bank of Brazil's website. 3 A “CNPJ” or corporate tax registration number.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

CHILE CHILE, A PLATFORM FOR INVESTMENTS INTO LATIN AMERICA

By Anthony Cook Santiago

Chile introduced a new investment vehicle for foreign investors in 2002 with a view to promoting investment in the country and making Chile attractive as a platform for investment into other Latin American markets. The beneficial tax regime, contained in article 41D of the Chilean Income Tax Law, is available to foreign investors that set up a Chilean publicly traded stock corporation or a closely held stock corporation. If investment is made through a closely held company, the company must elect to be governed by the rules applying to publicly traded companies and therefore, be subject to the regulatory control of the Chilean SEC. Under the regime, qualified investors (hereinafter “41D entities”) and their shareholders are exempt from tax on dividend distributions and capital gains derived from the disposition of shares. Specifically, 41D entities are subject to preferential tax rules rather than the general income tax provisions, except for withholding tax rules and the rules governing the disclosure of information to public authorities with respect to the contribution and withdrawal of capital, income and profits derived from activities undertaken abroad, and expenses and disbursements in undertaking such activities. To maintain consistency with the general tax system, 41D entities are deemed to be domiciled outside Chile for income tax purposes. Under the article 41D rules, a foreign investor may set up a corporation in Chile and through it invest in shares or rights of companies in other countries, without being subject to tax on dividends or capital gains or on fees for services provided to entities in which the 41D entity has invested. Likewise, no taxes are imposed on dividends declared by the 41D entity or on capital gains derived from the disposition of shares. To qualify for the regime, the following requirements must be met: · The exclusive purpose of the entity must be the undertaking of investments abroad in shares or rights in foreign companies or in convertible bonds, or in Chilean stock corporations. The only exception to this rule is that the entity may provide remunerated services to foreign companies that are owned by the 41D entity if the services are related to the activities of the foreign companies. · Although shareholders of a 41D entity may be domestic or foreign individuals or entities, shareholders that are legal entities and that hold at least a 10% interest in the entity may not be resident in a country that is considered a tax haven or a jurisdiction with a harmful preferential tax regime. Foreign shareholders in 41D entities must hold at least 25% of the capital or profits of the entity, and Chilean shareholders may participate up to a 75% investment. The participation composition must remain within the 25/75 ratio during the entire life of the company; otherwise, 41D entity status is lost. Chilean shareholders do not enjoy the benefits enjoyed by foreign shareholders on dividends distributed by the 41D entity or from the capital gains tax exemption.

· Capital contributions may be made in foreign currency or may be in the form of shares of a Chilean or foreign corporation or an interest in a foreign partnership. This is not always possible, however, as the foreign investment laws have not yet been brought fully into line with the 41D regime. Capital contributions must be made in accordance with one of the foreign investment regimes, i.e. Decree Law 600 (for investments, the minimum amount is US$ 5 million) or Chapter XIV of the Central Bank's Foreign Exchange Regulations. Decree Law 600 currently does not permit contributions in shares or partnership interests, and it is unclear whether a contribution of shares or interests of a foreign entity are permitted under Chapter XIV without prior approval of the Chilean Central Bank. As a result, only contributions in cash can be made without advance approval of the Central Bank. Entities benefiting from 41d status must maintain complete accounting records; the records may be maintained in foreign currency unless the company opts to use local currency. The company must be registered in a special register kept by the Chilean tax authorities for this purpose. Additional capital contributions, investments abroad or other operations or remittances abroad must be made in accordance with the requirements of the tax authorities. Foreign investments made by the 41D entity itself may be in shares or rights in foreign companies or in other securities that are convertible into shares. However, the investment entities may not be located in a listed tax haven jurisdiction. Entities benefiting from 41D status are subject to taxation on their Chilean-source income in the same manner as any other nonresident entity, subject to taxes in Chile only on Chilean source income. If shares in a 41D entity are sold to a person resident in a listed tax haven jurisdiction, 41D tax treatment is lost for the purchaser. Companies subject to article 41D do not benefit from the banking secrecy laws or the reserves established by the General Banking Law. If the company ceases to meet any of the requirements, the general income tax provisions apply. The 41D regime generally is a useful vehicle for certain investors and in specific situations. However, restrictions such as the need to set up a regulated corporation, the waiver of bank secrecy laws and the prohibition on investments in tax havens may make the regime less attractive. This particularly may be the case since Chile's growing tax treaty network and the foreign tax credit rules also offer a viable alternative for channeling investments into the Latin American region. Nevertheless, on balance, the article 41D rules are a valuable addition to the investment alternatives available to foreign investors seeking to invest through a country with a stable political and financial environment and adequate infrastructure.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

COLOMBIA Colombian Transfer Pricing Rules
By Andrés Parra Bogota Colombia's transfer pricing rules, enacted on 27 December 2002, entered into effect 1 January 2004. The transfer pricing rules generally adopt the arm's length principle and are applicable to transactions between Colombian taxpayers and related parties located abroad. The rules also are used to determine assets and liabilities between related parties.

Concept of related party For Colombian tax purposes, parties are deemed to be related when a person holds 50% or more of the capital of another company, holds a simple majority of the voting rights of another company or controls, directly or indirectly, another company. Control can be individual or joint, without participation in the stock of the subordinated company or by a principal home office located abroad, or by individuals. The concept of related parties also extends to branches and agencies. According to the Colombian Tax Code, there is an economic link between companies (thus giving rise to related party status) in the following cases, among others: · · · · · A head office and a subordinated entity; Two subordinate entities of the same head office; Two companies, whose shares are at least 50% owned, directly or indirectly, by the same individual or corporation; A company or a partner, shareholder or joint owners own 50% or more of the capital of the company and have the right to administer the company; or A company or related companies thereof and a manufacturer where the manufacturer sells more than 50% of the company's production.

Transactions with entities (whether or not related) that are located or functioning in a tax haven (as defined by the Colombian government) are presumed to be related party transactions. The criteria used to determine tax haven status include the following: · · · · No or low taxation as compared to the taxation of similar income in Colombia; Lack of an effective exchange of information program or practice; Lack of transparency; and Absence of requirements that a real economic activity be carried out by entities located in the jurisdiction.

The government will issue a list of jurisdictions that are deemed to be tax havens for these purposes.

Applicable transfer pricing methods Colombian laws specifies the following six transfer pricing methods as acceptable methods in determining prices or profit margins in controlled transactions: 1) Comparable Uncontrolled Price Method 2) Resale Price Method 3) Cost Plus Method 4) Profit Split Method 5) Residual Profit Split Method 6) Transactional Net Margin Method Colombian legislation applies the “best method rule,” whereby the method applied is the most appropriate to the transaction being analyzed.

Documentation and filing requirements According to Law 863 of 29 December 2003, taxpayers with a gross equity equal to or higher than 5,000 minimum legal wages (approximately US $653,300) or gross income equal to or higher than 3,000 minimum legal wages (approximately US $392,000) that carry out transactions with related parties domiciled abroad must maintain documentation and comply with filing requirements. Documentation must be prepared and maintained to demonstrate compliance with the transfer pricing rules (and retained for five years), and the information must be available upon the request of the tax authorities. In addition to the documentation requirements, taxpayers that exceed the above thresholds must file an annual transfer pricing return that includes information regarding transactions with related parties. It should be noted, however, that Law 863 does not specify the precise information that must be included in the return. The filing obligation applies as from taxable year 2004. Although no regulations have been issued, it is our understanding that the return must be filed in the early part of fiscal year 2005. Penalties The following penalties are included in the Colombian transfer pricing rules: Documentation Documentation Submitted Late, Contains Mistakes or Does not Allow Verification of Compliance Value of the transactions can be established Value of the transactions cannot be established No income 1% of the total value of transactions with related parties in the fiscal year. Penalties could reach Col$ 500 million (approximately US$ 182,500) 0.5% of reported net income in the income tax return in the same fiscal year or in the last return filed 0.5% of total assets reported in the income tax return of the same fiscal year or in the last return filed, up to Col$ 500 million

Failure to File Value of the transactions can be established Value of the transactions cannot be established No income 1% of the total value of transactions with related parties in the fiscal year. Penalties could reach Col$ 700 million (approximately US$ 255,500). Additionally, disallowance of costs and deductions 0.5% of the net income reported in the income tax return of the same fiscal year or in the last return filed 0.5% of the total assets reported in the income tax return of the same fiscal year or in the last return filed, up to Col$ 700 million Information Return Late Filing Value of the transactions can be established Value of the transactions cannot be established No income 1% per month or fraction thereof of transactions with related parties in the fiscal year, up to Col$ 700 million 0.5% of the net income reported in the income tax return of the same fiscal year or in the last return filed 0.5% of the total assets reported in the income tax return of the same fiscal year or in the last return filed, up to Col$ 700 million

If the transfer pricing return is filed after a Summons to Declare, the penalty is doubled, i.e. up to Col$ 1.4 million (approximately US$ 511,000) Amended Return 1% of the total transactions with related parties in the same fiscal year, up to Col$ 700 million Failure to File Value of the transactions can be established Value of the transactions cannot be established No income 20% of the total transactions with related parties of the same fiscal year, up to Col$ 700 million 10% of the net income reported in the income tax return of the same fiscal year or in the last return filed 10% of the total assets reported in the income tax return of the same fiscal year or in the last return filed, up to Col$ 700 million

In addition, if a transfer pricing adjustment is made by tax authorities, a fine up to 160% of the additional tax may be imposed. For fiscal year 2004, only the penalties relating to failure to file and late filing of the transfer pricing return, and penalties for amended returns are applicable. Penalties in other instances will not apply, even if the tax authorities conclude that an adjustment must be made to a reported transaction.

Advance pricing agreements (APAs) The Colombian tax authorities may enter into APAs with domestic or foreign taxpayers that will determine the prices or profit margins of the transactions carried out between related parties. APAs will be based on the transfer pricing methods and criteria established by law, and once approved, may cover the fiscal year requested, the previous fiscal year and up to three additional fiscal years after the year in which the APA application is filed. An APA may be approved without prejudice to the audit powers of the tax authorities. The tax authorities are required to approve or deny an APA request within nine months of the date the application is filed.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

COSTA RICA Integral Tax Reform

By Alan Saborio Costa Rica

Numerous factors have been identified in Costa Rica as triggering the deterioration of public finance, and various proposals have been tested throughout the years some partially successful, others not to mitigate the problem. The most recent effort has resulted in a proposal to amend certain tax rules, notably the income tax and the value added tax, as well as the rules governing tax administration, audit and collection. In addition, changes to the general law (Procedural Code and Commerce Code) are proposed to ensure the correct application of the amended rules. The proposed changes address fairness and equity issues, and balance the need to boost the public purse with the duty to take into account the economic capacity of the taxpayer. This is possible through the use of appropriate methods of raising revenue and controlling expenditure, leading to a fair tax system and financial justice. Below is a general description of the essential aspects of the current version of the proposed reformthe proposed measures may be further modified during the legislative process. Income Tax Changes are proposed to the rules governing resident individuals, companies and other entities as well as nonresident individuals and legal entities. The proposed amendments also would abolish the schedular tax system, where different taxes are imposed on different classes of income (e.g. salaries, interest, etc.) and introduce a single tax, and would move from a source-based system to a residence-based system, where all income of resident individuals and legal entities would be taxed in Costa Rica, regardless of where the income was derived. Another essential aspect of the proposed reform is the modification of the concept of income. The system would move from a ”result-based” concept (i.e. profit-based) to an “equity increase” concept (i.e. changes in the value of equity in a tax period). As a result, tax would be levied on capital gains and losses, and on transfers for no consideration (e.g. donations and legacies). As such, capital gains would form a special tax base in the case of individuals, and would be imposed together with a special regime for reinvestment in the case of legal entities. A withholding tax system also is proposed, whereby individuals who receive only salary income or whose salary income does not exceed a certain percentage of their total income would not be required to file an income tax return. It is also worth noting that, under the proposed reform, earnings derived from the financial market would be included in general taxable income. Value Added Tax The proposed reform would introduce a system that taxes both merchandise and fixed assets. The concept of “supply” would be expanded to cover the transfer of assets made by an enterprise, even if the assets were not sold in the ordinary course of business. The taxable event would be the delivery of the assets and not merely the sale of the merchandise. The VAT tax base would be the total price paid on a transaction subject to VAT The proposal sets . out what elements would be included or excluded from the tax base and proposes the possibility of modifying the tax base through reductions, such as the return of containers and packages, discounts granted after sale (e.g. for early payment) and irrecoverable debts.

Legal entities or individuals that are traders or professionals that supply goods or services subject to VAT within Costa Rica or that import goods would be responsible for collecting VAT . The rules regarding the deductibility of input tax credits would be revised. The “physical deduction” criterion, whereby a credit is granted only with respect to taxes paid on inputs that are physically incorporated in the goods or services supplied would be replaced by the “financial deduction” criterion, under which all VAT paid with respect to goods and services that are inputs of the relevant supply would be able to be credited. The credit, therefore, would be calculated from the accounting information that determines the added value at each stage. The proposed reform also includes a special regime for the deduction of VAT paid on the acquisition of capital assets. A full deduction would be allowed in the year in which the asset was acquired, but the deduction would need to be adjusted during the useful life of the asset if it was no longer used (in whole or in part) for the relevant activity. In that case, the amount disallowed would be assessed and paid to the Tax Office.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

ECUADOR Duty free zones in Ecuador

Dr. Pablo Naranjo Ribadeneira Lawyers, Quito

Owing to the economic situation in Latin America, countries such as Ecuador need to seek alternative ways of encouraging economic growth through measures that stimulate overseas trade and foreign investment. The implementation and growth of duty free zones in Ecuador have helped to provide the country with a greater share in international markets, an increase in exports and the creation of employment as well as the generating foreign currency, foreign investment and technology transfers and contributing to the development of depressed zones. The customs, tax and labour benefits offered by duty free zones also are attractive for both local and foreign investors. A duty free zone is an area located within the Ecuadorian territory subject to special measures with respect to foreign trade, customs, taxes, finance, capital and employment. Individuals and legal entities qualified as users in such areas undertake activities related to the production and marketing of goods for export or re-export, as well as the provision of services related to international trade or the provision of tourism, educational and hospital services. Ecuador currently has eight duty free zones, of which the following four are in operation: · · · · Esmeraldas Duty Free Zone CEM- ZOFREE (Decree No. 3540, published in Official Gazette No. 835 of December 18, 1987) in which 12 users are registered. Manabí Duty Free Zone -ZOFRAMA (Decree No. 3854, published in the Supplement to Official Gazette No. 963 of June 10, 1996), in which 49 users are registered. Cuenca Duty Free Zone CEM (Decree No. 807, published in Official Gazette No. 193 of November 13, 1997), in which 28 users are registered. Quito Duty Free Zone - METROZONA (Decree No. 644, published in Official Gazette 144 of March 9, 1999), in which 22 users are registered.

The following duty free zones are authorized to operate as from 2003: · · · · Manta Duty Free Zone ZONAMANTA (Decree No. 1331, published in the Supplement to Official Gazette No. 287 of March 19, 2001). El Oro Duty Free Zone ZOFRAORO (Decree No. 1443-B, published in Official Gazette No. 320 of May 7, 2001). Guayas Duty Free Zone ZOFRAGUA (Decree No. 1955-B, published in Official Gazette No. 439 of October 24, 2001). Ecuador Duty Free Zone ECUAZOFRA (Decree No. 2765, published in Official Gazette 611 of July 4, 2002).

Legal Framework Duty free zones are subject to laws and regulations included in the Duty Free Zone Law (Official Gazette No. 625 of February 19, 1991), its amending laws (Official Gazettes Nos. 462 and 149 of June 15, 1994 and March 16, 1999) and regulation (Official Gazette No. 624 of July 23, 2002, that

repeals the previous regulation and the reforms published in Official Gazette No. 769, 13-IX-91), as well as special legal standards aimed at creating, stimulating and governing the system.

Controlling entity Duty free zones are controlled by the National Council for Duty Free Zones (CONAZOFRA), whose principal purpose is to establish general policies for operations and supervision, as well as proposing the expediting, modification or elimination of legal standards or regulations related to the system, and analyzing requests for the establishment of duty free zones and issuing rulings in relation to such requests. CONAZOFRA also approves internal operational regulations for each duty free zone, which are drawn up by the relevant zone administration company, and imposes sanctions.

Qualification of duty free zones, administration companies and users Duty free zone and administration company The establishment and functioning of a duty free zone and its administration company is authorized through an Executive Decree issued by the President of Ecuador. Any public or private legal entity or mixed economy entity (i.e. a partly privatized entity) with the financial and operating capacity to comply with the free zone objectives may undertake the administration of a duty free zone. Qualification as a duty free zone and as a zone administration company is obtained by submitting a request to the Executive Director of CONAZOFRA, addressed to the President of Eucador, and attaching certified copies of the articles of incorporation of the requesting company, property deeds with regard to the land, general plans and the construction design of the area in which the duty free zone will operate, as well as a feasibility study. CONAZOFRA will issue a report detailing the economic and social benefits of establishing the proposed duty free zone; the legal and financial capacity of the company that will be the duty free zone administrator; the location, boundaries and area of the duty free zone; the investment amount and activities to be carried out in the zone; the estimated added value to the country; an estimate of the employment to be generated; an environmental impact report; and the project execution period. Upon receipt of the report from CONAZOFRA, the President will take a decision on the implementation of the duty free zone. If the implementation of the zone is authorized, CONAZOFRA will approve the internal regulations for the operation of the zone within 15 days.

Duty free zone users Any individual or legal entity, whether Ecuadorian or foreign, may request to undertake economic activities within a duty free zone. The following types of company can operate in duty free zones: · · · · Industrial (processing goods for export or re-export); Commercial (international trading in goods for import, export or re-export); Service (international services or services for the functioning of duty free zones); and Tourist services.

Individuals or entities seeking qualification as users must submit a request to the duty free zone company administrator specifying the activity to be developed; the products to be manufactured and traded; the services to be provided; the raw materials and packaging to be used; machinery,

equipment or inputs to be imported; the estimated number and technical or professional level of employees; the duration of the activity; and an environmental impact study. The request must be accompanied by the deeds of incorporation in the case of an Ecuadorian company or a certificate issued by the Ecuadorian consulate in the company's place of domicile in the case of a nonEcuadorian entity, together with a copy of a power of attorney for the appointment of a legal representative, and documents validating the financial and operating capacity of the applicant. Upon receipt of a request, the duty free zone administrator has 15 days to approve or deny the request and then 72 hours to inform the applicant of the decision. CONAZOFRA then will be informed of the decision within eight days.

Tax and customs benefits Administration companies and duty free zone users enjoy the following exemptions: Customs: · · Users are exempt from customs and excise duties on the import and export of merchandise, goods, raw materials, equipment, machinery and other inputs; and Administrators are exempt from customs and excise duties provided the import of equipment, machinery, materials and other inputs has been authorized by CONAZOFRA.

Other taxes: · · · · Exemption from income tax and any other substitute tax. Payments made by users for occasional services provided by foreign technicians also are exempt from income tax; Exemption from VAT ; Exemption from provincial and municipal taxes; Exemption from patent taxes and all other current taxes applicable to production, the use of patents and trademarks, and transfers of technology;

Duty free zone users enjoy tax exemptions for 20 years, with a possible extension if agreed by CONAZOFRA.

Labor Employees providing services in duty free zones are subject to standards set forth in the Labor Code. However, contracts governing the relationship between users and employees in duty free zones are temporary but may be renewed without any time limit, since employers are not obliged to comply with standards in Art. 14 of the Labor Code regarding minimum stability.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

MEXICO Cross-border structuring of transactions within the scope of tax treaties
by Luis Liñero Mexico City Determining the appropriate structure for cross-border transactions is essential, both for multinationals establishing operations in Mexico and for Mexican entities, and even individuals, whose business requires interaction with nonresidents. Often, the first document consulted in planning for the tax effects of a cross-border transaction will be the tax treaty between Mexico and the relevant foreign country. Although Mexico historically had a set of rules for determining the tax regime applicable to payments to nonresidents, only 12 years have passed since Mexico concluded its first tax treaty, that with Canada, which entered into effect in 1992. Because of Mexico's relatively brief experience with tax treaties, there are few Mexican judicial precedents on the correct application or interpretation of treaties. In addition, unlike under the common law systems of the US and the UK, under Mexico's civil law system, court decisions serve as persuasive, rather than binding, precedent. However, the courts have resolved that Mexico's tax treaties carry greater authority than its income tax law. Further, the Mexican rules recognize the relevance of the commentary to the OECD model treaty in interpreting tax treaties. Apart from the factors commonly taken into account in determining the correct application of a tax treaty to a particular transaction, three key issues must be considered in determining the application of Mexico's tax treaties: the relationship between form and substance, the effective beneficiary principle and rules relating to particular kinds of income and transactions. Form versus substance The form of a transaction (as opposed to its substance) has long carried greater weight in the context of Mexico's tax rules. To some extent, this approach is now being rejected and replaced by an approach that increasingly focuses on the substance of the relevant contract. Two factors are of particular importance in establishing the substance of a transaction: the existence of a demonstrable, genuine business transaction and the proper characterization of a transaction, regardless of how the relevant contract is constituted. Because of the disproportionate weight historically given to the form of a transaction, contracting parties resident outside Mexico often envisage that, to the extent an agreement is in place and an invoice charging the appropriate fee has been issued, the Mexican payer should have no difficulty in obtaining a deduction for the relevant payment, an assumption that is no longer incorrect. At audit, Ministry of Finance inspectors request documentation supporting the service provided to determine the deductibility of a payment. Moreover, with the growing sophistication of the Ministry of Finance inspectors, taxpayers can expect an examination of the substance of their contracts. To take one example, a determination that a contract is in substance a contract for technical services, rather than a contract for technical assistance, may result in the application of a different tax regime. Effective beneficiary principle The effective beneficiary principle cannot be considered in isolation from the related concepts of limitation-on-benefits and transparency. Although it is clear that, in applying a tax treaty, there

should be evidence to demonstrate that the recipient of a payment is a resident of the relevant treaty country and the effective beneficiary of the payment, some of Mexico's treaties (e.g. those with the US, UK and Singapore) include articles that specifically limit the availability of treaty benefits. Special attention is required when structuring or analyzing transactions involving residents of any countries with particular rules to this effect in their tax treaties.

Transparency In principle, the Mexican tax authorities do not recognize the existence of pass-through entities in applying treaty benefits. Because a pass-through is not regarded as a taxpayer, it will not be eligible for treaty benefits. Nor, if an interposed entity is a pass-through and therefore not regarded as a taxpayer, will Mexico look through the entity to consider the eligibility for treaty benefits of any of the entity's interest holders. Under a paragraph included in the protocol to the Mexico-US treaty, Mexico and the US have agreed that, when a recipient of income is a non-taxpayer entity (i.e. a partnership, estate or trust) resident in one of the contracting states, treaty benefits may be available to the extent the related income is taxable in the hands of the partners or beneficiaries of the non-taxpayer entity. Other than this provision, there are no direct references in any of Mexico's treaties that establish rules regarding transparency.

Mexico has only one kind of entity that could perhaps be viewed as a pass-through entity for tax purposes. That is the business trust, under which the fiduciary body, generally a bank, is responsible for the preparation and filing of the estimated payments of the business activities carried out by the trust.

Tax treaty benefits With respect to the application of tax treaty benefits under domestic income tax law, benefits should be available provided it is demonstrated that: the recipient of the income is resident in a tax treaty country; the treaty provisions, if any, are applicable; and local law has been complied with. To prove tax residence, the taxpayer must present a certificate of tax residence issued by the other country's tax administration or a copy of the tax return. For Mexico, local law procedures range from registering with the Mexican tax authorities (required, for example, where a foreign bank grants a loan to a Mexican resident) to appointing legal representatives and filing certain notices claiming that income is not taxable in Mexico under the terms of the relevant treaty (e.g. in the case of a sale of shares, or a merger or restructuring transaction that is specifically protected by the treaty). If, for any reason, the payor does not apply the terms of the treaty in making a payment (e.g. the payor was not satisfied that the payee fully demonstrated it was eligible for benefits), a refund can be sought for the difference between the taxpayer's liability, taking into account the effect of the treaty and that arising purely under Mexico's domestic law.

A final note on eligibility Because the local tax regime may provide for treating certain income items as favorably as or more favorably than the terms of the applicable treaty, it may not be necessary to consider the effective beneficiary principles.

Rules on particular kinds of income/transactions Withholding tax rates

The maximum withholding tax rates provided for in Mexico's existing treaties are as follows: Country of recipient Australia Belgium Canada Chile Denmark Ecuador Finland France Germany Ireland Israel Italy Japan Luxembourg Netherlands Norway Portugal Romania Singapore South Korea Spain Sweden Switzerland UK US Interest(%) 15/10 15/10 10 15 15/5 15/10 15/10 15/10 15/10 10/5 10 10 15/10 10 15/10 15/10 10 15 15/5 15/5 15/5 15/10 15/10 15/10 15/10 Royalties (%) 10 10 10 15 10 10 10 10 10 10 10 15 10 10 10 10 10 10 10 10 10 10 10 10 10

Mexico's tax treaties generally distinguish between interest paid to individuals and parent companies (taxed at a higher rate and represented by the first figure in the interest column) and interest paid to banks or other institutional lenders (taxed at a lower rate and represented by the second of the two figures in the interest column). Withholding rates on interest and royalties under Mexico's domestic law, where there is no treaty protection, are 4.9%, 10%, 15%, 21% and 33% in the case of interest, depending on the nature of the debt and the recipient's activity (i.e. a

bank, fixed assets supplier, etc.), and 25% or 33% for royalty payments. In 1995, the Mexican government unilaterally reduced the withholding tax on foreign financial operations involving banks or brokerages in countries with which Mexico has tax treaties (to 4.9%).

Royalties The 2003 update to the OECD Model Treaty includes an observation by Mexico dealing with the application of the withholding rules as they apply to royalty payments for the use of software. The observation seems to represent a complete reversal of the way in which such payments were previously dealt with under those rules. The observation reads as follows:

29 Mexico holds the view that payments relating to software fall within the scope of the Article [12] where less than the full rights to software are transferred, either if the payments are in consideration for the right to use a copyright on software for commercial exploitation or if they relate to software acquired for the business use of the purchaser. Before the publication of the observation, the Ministry of Finance issued particular rulings confirming what should have been the interpretation based on the previous and the current commentaries, meaning that a payment for the use or implementation of a software without having full rights to exploit it commercially, was not considered to be subject to the royalty payments article of the treaty, and, therefore, was considered a business profit not subject to withholding taxes.

As a general rule, any particular interpretation of the royalty provisions of a specific Mexican treaty must be made in a context that takes the negotiating parties' positions into consideration. However, the nature of the observation seems to indicate that the Ministry of Finance will seek to apply the withholding provisions to all kinds of software payments even where such payments are made to residents of countries that already had a treaty signed and in effect before the publication of the observation. The Ministry of Finance bases its position on the ambulatory approach to the interpretation of treaties.

As the OECD commentary is widely applied in interpreting treaty provisions, Mexican entities should analyze their payment agreements to determine whether their payments fall within the description of royalties included in the commentary, analyzing the kind of rights from which the payor can benefit. As the opinion of the Ministry of Finance is that every payment related to the use of software should be subject to taxation, companies making such payments to non-residents will need to undertake a more in-depth analysis of those payments, including an analysis of contracts in place before January 28, 2003 to determine the tax regime appropriate to each particular agreement.

Reorganization rule With respect to the sale of shares in a Mexican entity, the reorganization rules in the income tax law confer benefits on transactions that might otherwise be taxable even where there is an applicable tax treaty. Under the reorganization rules, tax arising from the transfer of shares may be deferred (but updated for inflation) until the date on which the shares leave the group within which they were transferred. To avoid any potentially unfavorable consequences, an advance ruling from the Ministry of Finance should be obtained. An exchange of shares sometimes is made without establishing that the transaction does not create a Mexican source of income and, consequently, a potential Mexican tax liability. For example, the parties to the transaction may have assumed that Mexican-source income is not generated if the sale is made between

nonresidents. Such an assumption is not correct and, where the parties to the sale are nonresidents, the reorganization rule will not apply.

Interest payments Another issue that often arises relates to the characterization of payments as “interest” payments, particularly in the context of the Mexican rule addressing back-to-back loans. Ignorance of the back-to-back rule and the tax authorities' aggressive interpretation of the rule exposes a taxpayer to the risk of deemed dividend characterization. The back-to-back loan rule provides that, if a person provides cash, assets or services to another person who, at the same time, provides cash, assets or services to the first person or to a party related to the first person, the interest payments derived from such transaction may not be deducted and are considered deemed dividends.

Asset tax Asset tax, which is akin to the alternative minimum tax of the US and other countries, is a contribution that must be paid when the corporate income tax liability is lower than a minimum threshold or where no corporate income tax liability arises in a particular period.

The asset tax is levied on individuals and entities resident in Mexico, as well as permanent establishments of nonresidents in Mexico and nonresidents granting the use of assets in Mexico. Certain of Mexico's tax treaties include provisions granting virtual credits to offset the effect of the asset tax. However, because such credits are not always sufficient, projections must be made and the structuring of deals carefully planned. This is particularly important in the case of asset tax on nonresidents, because the nonresidents may not be able to offset the asset tax against future income tax, as residents are able to do.

Dangers of using a tax haven The use of a tax haven jurisdiction (either for receiving payments from Mexico or as a location for a subsidiary of a Mexican entity) gives rise to complications for cross-border transactions involving all types of income. Withholding tax rates up of up to 40% may be imposed on the gross proceeds or the results may have to be recognized as taxable income regardless of whether income is distributed.

“A version of this article appeared in International Tax Review's Guide to Mexico in December 2003.”

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

PERU MULTINATIONAL GROUPS AND INTRAGROUP SERVICES
by Víctor Vásquez Lima

The reduction of barriers to international trade and the increase in bilateral and multilateral trade agreements are only two factors that have contributed to a global economy with unprecedented foreign trade. This new environment has given rise to an increase in foreign investment in various countries, and the participation by corporations and multinational groups in foreign trade (60% of foreign trade); It is estimated that “intragroup” transactionsi.e. transactions between companies belonging to the same economic grouprepresent approximately one-half of the foreign trade conducted by corporations. This environment, together with the diversity of tax rates in different countries, and the variety of tax benefits granted to certain companies or sectors and, as in the case of Peru, the existence of tax legal stability agreements, among other factors, lends a particular significance to the “intragroup services” issue within the general transfer pricing area. Although groups have a legitimate right to maximise benefits, deriving their profits in countries with a lower tax burden, as allowed by national legislation, tax authorities worldwide have sought to protect their tax bases by introducing laws and regulations on transfer pricing. Peru has not been a stranger to this trend, having introduced its own rather succinct transfer pricing rules in 2001. More precise legislation entered into force as from January 1, 2004. The new rules clearly define the methods to be used in determining the market value of transactions between related companies, specify the scope of adjustments, establish the requirement to file an annual information return (i.e. a sworn statement) and permit reference to the OECD transfer pricing guidelines. The latter point is the reason for this article, as the new regulations specifically indicate that the OECD transfer pricing guidelines are to be used for the interpretation of the Peruvian rules, provided they do not contradict the Peruvian Income Tax Law. Thus, it is important to determine whether the law permits the application of the OECD guidelines only for specific issues or whether the guidelines may be applied more generally to other aspects of transfer pricing, such as intragroup services and cost contribution arrangements. Issues relating to intragroup services include determining the appropriate charges for costs incurred in rendering such services plus a profitability margin; rendering such services at cost; and the shareholders' activities, the cost of which should be absorbed only by the parent company. A related issue is that of cost contribution arrangements, whereby a service is provided that benefits several companies in a group, and the costs incurred are allocated among the companies benefiting from the service (such as in the cases of co-ownership of intangibles), among other aspects.

Intragroup Services The analysis of the services performed in intragroup transactions is particularly important because it raises more specific issues than other types of transactions between related companies.

Intragroup services are carried out to centralize functions within a group to reduce group costs and enhance competitive advantage. Chapter VII of the OECD transfer pricing guidelines recognises the existence of services provided between affiliates in most groups, such as administrative, technical, management, commercial, logistics, coordination, control, and other services, which also may be performed by unrelated third parties. A particular characteristic of intragroup services is that the cost of their provision may be assumed by the parent company, or by one of the companies in the group specifically engaged in providing a particular type of service (service centre). Under the arm's length principle, an activity is considered an intragroup service when it provides economic or commercial value that maintains or enhances the commercial position of the company that receives the service. In this sense, an intragroup service may be identified if the recipient company that requires the service would be willing to hire an independent third party to carry out the service or would perform the service itself. A service that duplicates functions will not be considered an intragroup service, unless the purpose of the service is to reduce business risks (e.g. obtain a second legal opinion) or if the service is performed on a temporary basis within the group's reorganisation process. It should be noted that some intragroup services may be provided to any or all group companies even if not required by the companies and even if they would not be willing to hire an independent provider to perform the services. In the latter case, the rendering of the services would not justify a charge to the recipient companies because the service would not be necessary since the recipient companies would not be willing to hire an independent provider or use their own resources to provide the services. These types of services are known as shareholders' activities. Shareholders' activities are activities not directly necessary for the subsidiary and, therefore, should not be charged. Examples of shareholders' activities include consolidation of financial statements, board of directors' costs, and costs incurred in obtaining financing to increase the share participation in subsidiaries. In general, shareholders' activities are understood to be any activity a group company would perform to safeguard and protect its investment. Services that would qualify as shareholders' activities would not, by definition, be considered intragroup services, because a shareholder's activities are of interest to the shareholder only and, therefore, the subsidiaries would have not been willing to hire a third party or use their own resources to perform such activities. On the other hand, services a subsidiary or, in general, a related company would need and would be willing to hire a third party to carry out or to use its own resources to provide are considered intragroup services. Examples of such services include:

1) Administrative services, such as accounting, audit, factoring, information (systems), planning, coordination, budget control, legal; 2) Financial services, such as financial advice, cash flows and solvency supervision, capital increases, loan contracts, interest and exchange risk management, and refinancing; 3) Assistance services in the production, purchasing, distribution and marketing areas; 4) Personnel services, such as recruiting and training; 5) “On call” services that could comprise, among others, financial, management, technical and legal advice; 6) Technical assistance services, management services, and research and development services.

The validity of “on call” services may be determined by examining whether the provider company has the necessary staff and equipment available to carry out the services. The charging of rates for “stand-by costs” to ensure availability of necessary resources to provide on call services would be considered a market activity, since it would be made by an independent company under comparable conditions. Multinational groups also have service centres responsible for conducting research and development, or administering and protecting intangible property for all group companies, such as services related to (5) above. Such activities are considered to be intragroup services from the “market value” perspective, since they are activities for which there a third party would be hired or the services would be performed with a company's own resources.

Cost Contribution Arrangements Cost contribution arrangements (CCAs) are arrangements whereby companies (related or unrelated) agree to share costs and risks for developing, producing or obtaining assets (tangible or intangible), services or rights; and to determine the nature and extent of the interest of participant in the assets, services or rights. According to what is established in Chapter VII of the OECD transfer pricing guidelines, CCAs also are used in Peru when a service centre benefits from the rendering of the services or when there is no service centre and two or more companies each use their own resources in a supplementary manner, or when the resources of independent third parties are used to provide a service or create an intangible. A CCA is not a method but merely an allocation of costs incurred for the rendering of a service or creation of an intangible. A CCA must adhere to the arm's length principle. The contribution of costs among participants in a CCA should be in proportion to the expected benefits each of participant, and the charge must not contain any margin. Adherence to the arm's length principle implies that contributions are consistent with what independent companies would have agreed, given comparable conditions and reasonably expected benefits. It is obvious that the rendering of these services should entail remuneration. In this respect, the question arises whether a profit margin should be charged or should the services be charged at cost or below cost? Normally, an independent company would try to charge a price that would produce a profit; hence, as a rule, every provision of services should imply the obtaining of a profit margin. However, under certain circumstances, an independent company may not obtain any benefits from rendering a service. This could occur, for instance, when the service provider's costs exceed market price yet, mainly due to commercial strategies, the provider is willing to provide the service anyway to increase or supplement the range of profitable services it provides, to offer a more complete service, thus obtaining comparative advantages and increasing its global profitability. A business decision to operate at a loss in some activity or service to increase global profitability, may be found, for example, in the cellular telephone industry, where companies deliver cellular equipment to supplement the rendering of interconnection services, and incur losses as part of their commercial strategy. In this case, the companies are willing to lose in one specific activity to increase the number of persons who require interconnection services, which is its main activity, thus increasing profitability.

Observing that these practices occur between independent third parties, the OECD guidelines mention that the market value of a service may be lower than the costs incurred by a company in

providing the service to its related companies; for example, if the service does not correspond to the business activity (it is not a routine activity of a company belonging to a group, but is provided incidentally as the group sees fit). However, the group may determine that the service be provided within the group rather than hire an independent third party. In that case, the OECD guidelines do not consider it appropriate to increase the price to ensure a profit margin is obtained: such a result would be not be in accordance with the arm's length principle, because the difference between the price agreed by related companies and the price agreed by independent third parties (market value) would increase. Thus, it is not necessary that a market price generate profits for a related company that provides services to a group, because for independent third parties, the service's agreed price (or as in the case of cellular telephone services) may not always generate an accounting benefit for the company providing the service. In addition to the OECD stipulations, international experience demonstrates the acceptance of services rendered at cost between related companies domiciled in different countries. In Mexico, it is customary to prepare transfer pricing technical studies which justify the rendering or receiving of administrative services at cost. As far as we know, the Mexican tax authorities have never objected to this practice. Another example can be found in the U.S. proposed intercompany services regulations. The regulations propose the so-called simplified method, a method mainly used for administrative and management services. This method allows only a charge of costs, i.e. a margin of 0% if the median of the range comprising the profitability of independent companies providing similar services (market range) is lower than 6%. Arguably, the possibility of not applying a margin for rendering services occurs in the case of minor services (which do not correspond to a company's main cost or expense) or when the market profitability for the services is small (as previously mentioned, and noticed in the median of the range of profitability of comparable companies). In essence, the attitude of the tax authorities mentioned above is similar: both accept the rendering of services without a profit margin. One, by accepting transfer pricing reports in which transactions (using the provisions of chapter VII of the OECD transfer pricing guidelines) are justified, and the other by proposing to turn this practice into a norm. Transfer pricing has become more important in Peru, because as from January 1, 2004, the legislation is more detailed and stringent than previously, as well as the requirement to file a special information return. Within this context, the OECD guidelines should be used as a reference for aspects not specifically contemplated in the legislation, such as in the case of intragroup services.
It should be noted that an alliance between companies to share costs is common for independent third parties. There are cases in the pharmaceutical industrye.g. the alliances between Pfizer-Boehringer Ingelheim to create Mirapax (pramipexola) in 1992, Pfizer-Spiriva to create tiotropium in 2001 and Pfizer-G.D. Searle to create Celebrex in 1998. These alliances to share research costs or costs incurred in the creation of new products are also common in the communications and software industries, among others. For example, one company carries out the management aspects and a related company the administrative aspects, but both aspects are necessary to operate the companies; both companies use their own resources in a supplementary manner and share managers and administrative personnel, thus reducing labour costs. CCAs are commonly used to create intangibles: two or more companies share the costs associated with the creation of the intangible, as well as the expected benefits and risks. Therefore, both are ownersone party does not pay royalties to the other party, but rather charges third parties that require the licence to use the intangible. This method is used for these services, provided they are not rendered to independent third parties, there is no transfer of intangibles, among other aspects.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

Uruguay Tax Asymmetries in Mercosur By Carlos Borba Montevideo Multinational enterprises are, by their nature, in a unique position to benefit from the advantages that result from doing business simultaneously in different countries. The path to achieving optimized tax costs, however, also is pitted with hazards, requiring careful contemplation of a variety of issues. Even if a multinational operates within a common market, uniformity of tax rules is rare. Nevertheless, for the multinational willing to undertake an exercise in coordinating benefits, the results can be extremely beneficial. To that end, we provide a brief examination of the considerations for multinationals operating within the Southern Common Market (Mercosur). Mercosur was formed in 1991 by Argentina, Brazil, Paraguay and Uruguay with the signing of the Treaty of Asunción. Association agreements were signed with Chile and Bolivia in the mid-1990s. During the 1990s, the Mercosur countries applied source-based (i.e. territorial) systems for taxing income. As economic realities changed, however, so, too, did the tax rules, with Brazil and Argentina (arguably the economic powerhouses of Mercosur) adopting residence-based (i.e. worldwide) systems. Reflecting geographic and political needs as well as a desire to attract investment, other tax measuressuch as tax holidays, special customs zones, tax free ports and customs exemptionshave added to the differences between the tax systems of the Mercosur countries. While legitimate exercises of each country's legislative powers, these variances can and do result in double taxation and harmful tax competition between the countries. The difficulty in achieving tax harmonization among the Mercosur countries, particularly in the short term, is further complicated by the considerable differences between Argentina and Brazil and the remaining, economically smaller, Mercosur partners. It would be more feasible to initiate discussions on the roles of each country in the context of the common market. Specifically, the countries should work toward a model closer to that of the European Union, recognizing the differences between the Mercosur member countries. Such an endeavor would take account of each country's objectives as well as specific economic, geographic, territorial and cultural circumstances. Despite the stated importance of Mercosur's development to Argentina's and Brazil's newly elected presidents, taxpayers should not expect progress on tax harmonization in the foreseeable future. Issues that would need to be resolved before harmonization can take place are exceedingly complex and require consideration by governments mired in traditional political bureaucracy from which hasty decisions cannot be expected. In the interim, multinationals are left with trying to obtain the best that this asymmetry of tax rules has to offer while avoiding the specter of double taxation.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
Deloitte. Colombia

VENEZUELA Limitations on deduction of costs and expenses of PEs in Venezuela

By Humberto Romero-Muci and Patricia Ferrer Caracas

Recently published regulations issued by the Venezuelan government establish conditions for the deductibility of management and administrative expenses allocated by a head office to its permanent establishment (PE), as well as limitations on the deductibility of certain payments made by a PE to its head office, to other PEs of the head office or to related parties.

Venezuelan resident entities and individuals became subject to worldwide taxation as from January 1, 2001. PEs of foreign entities located in Venezuela also became taxed on worldwide income attributable to the activities performed, directly or indirectly, by the PE.

Venezuelan income tax rules broadly define a PE to include a fixed place of business, office or center owned by a nonresident entity, either directly or through an agent, employee or representative, where the nonresident's activities are wholly or partly carried on. It includes a headquarters, branch, office, factory, shop, facility, warehouse, store or other establishment. Construction, installation or assembly projects that last longer than six months, as well as activities related to the exploitation or extraction of mines, hydrocarbons, agriculture, forestry or livestock or other natural resources fall within the definition of PE. Professional services carried out by an entity or its agent or representative also may give rise to PE status. An agent acting independently will not be deemed to be a PE unless the agent has authority to conclude contracts in the name of the principal. Facilities used permanently by an entrepreneur or professional, centers for the acquisition of goods and services and real property used through leasing also are considered fixed places of businesses for purposes of the PE definition.

General management and administrative expenses A PE may deduct general management and administrative expenses incurred (in Venezuela or abroad) for purposes of carrying out its activities provided the following requirements are met:

1) The taxpayer can support and verify the expenses; 2) The expenses are recorded in the financial statements of the PE; 3) The allocation of the expenses is reasonable and permanent; and 4) The criteria used by the head office to allocate the expenses has been approved by the tax authorities. With respect to condition 3), the regulations provide that the reasonableness of the expenses will be assessed based on the proportion that the management and administration services supplied to the PE bear to the total management and administration services supplied by the head office If it is not possible to use this criterion, the allocation may be made by reference to any of the following criteria: business profits, direct costs and expenses, the average investment in fixed assets used in the PE's economic activities or the average investment in all assets used in the PE's

economic activities. The methods for allocating management and general administrative expenses likely should be in accordance with the OECD transfer pricing guidelines (although this is not clear in the regulations).

To obtain approval of the tax authorities for the deductibility of general management and administrative expenses, the PE must submit a request within the first 60 business days of its fiscal year. Once the request is filed, the tax authorities have 90 business days to approve or deny the request. If the tax authorities do not respond, the request is deemed to be denied and, therefore, no deduction will be allowed.

The taxpayer must attach to its final income tax return the management and administrative expense allocation criteria approved by the tax authorities.

Royalties, technical assistance fees and similar payments Limitations also are imposed on the deductibility of royalties, technical assistance fees and similar payments when the payments are made by a PE to its head office, other PEs of the head office, subsidiaries, affiliates or related parties, unless the payments represent a reimbursement of expenses.

The limitation on deductibility of such payments is based on the fact that the PE and its head office and other PEs of the head office are deemed to be a single legal entity. However, this limitation does not seem reasonable when considering that, in determining the income attributable to the activities of the PE, it is treated as a separate legal entity from that of its head office. The limitation on deductibility also applies to payments made by a PE to subsidiaries, affiliates and other related parties. With respect to payments made by a PE to related parties, it is worth noting that Venezuela's tax treaties with the United States, Norway, Indonesia, Barbados, Denmark, Canada, Czech Republic, the United Kingdom, Portugal and Trinidad and Tobago only limit the deductibility of payments made by a PE to its head office and other PEs of the head officeno limitation is imposed on payments made to related parties.

Conclusion The presumption that, if the tax authorities do not respond to a taxpayer request regarding the allocation method used by the head office, the request is deemed to be denied, resulting in a disallowance of the deduction of general management and administrative expenses violates the constitutional principle according to which taxpayers should be taxed based on their economic capacity. The presumption also may be illegal as it exceeds the rules in the Income Tax Law that regulate the deduction of such expenses. Further, that same unconstitutionality argument should apply with respect to the limitation on the deductibility of royalty, technical assistance and similar payments made by a PE to related parties. Thus, an administrative decision disallowing the deduction of any of these expenses and/or payments could be appealed to the tax courts. However, until a taxpayer takes that step and a tax court declares the provision to be unconstitutional, the regulation remains in effect and must be followed.

© 2004 Deloitte Touche T ohmatsu. All rights reserved.
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