Transfer pricing rules and the Chilean tax reform
Lorenzo Gálmez M and Roberto Carlos Rivas of PwC provide an update on the Chilean tax reform and its impact on transfer pricing.
On April 1 2014, a new and extensive Tax Reform Bill was presented to the Chilean Parliament by the Executive. The tax reform should be expected, in accordance with the message of the Government, to introduce profound and structural changes to the Chilean tax system to increase the actual tax burden and to be able to finance relevant modifications to the education system.
Furthermore, in accordance with the Executive, the tax reform will try to correct the existing tax disparity situation by generating a higher redistribution of the income, together with the concern of making sure that taxes are paid as they are due in accordance with the law, diminishing tax avoidance and tax elusion possibilities.
The Tax Reform has been presented as a gradual modification of the Tax System with full effects from year 2017 onwards, but its first changes will come into force within taxable year 2015. The Tax Reform is currently under the analysis and discussion of the Senate so some changes may still be expected.
The tax reform considers, among other matters, an increase of tax rates and tax bases, the elimination of certain tax benefits and tax incentives, the empowerment of the Chilean tax authority, and the elimination of the taxable earnings ledger (FUT). This last point, the elimination of the FUT, is considered by the Executive, as being the core of the tax reform and comprehends a significant alteration of the Chilean tax system where final taxpayers will be taxed over income on an attributed basis, whilst today a type of legal tax deferral is available.
Together with the above, the tax reform considers the inclusion of a sort of substance-over-form regulation and new general and significant anti-elusion rules into the Chilean Income Tax Law (ITL).
Article 41E of the Chilean ITL contains Chilean local transfer pricing (TP) rules applicable for Chilean taxpayers. These rules have been in force since September 27 2012 and in general resemble TP rules from the OECD guidelines. Article 41E will not face any structural changes with the tax reform, but it will become a key element of interpretation and a tool for fiscal control of the Tax Authority. The awareness, understanding and application of TP rules and economic substance will become essential in the Chilean tax arena in general.
Transfer pricing rules and the Chilean tax reform
The tax reform considers the inclusion of a sort of general substance-over-form regulation and new significant anti-elusion rules into the Chilean ITL. These rules, among other effects, will incentivise the use of legal structures only for cases where a relevant economic ingredient and its effects can be demonstrated.
The local tax authority will be empowered to interpret and assess the legal form of operations according to the business being carried out, notwithstanding the labels or legal forms that the parties have disclosed.
Furthermore, where a deferral of taxes is obtained by the use of specific legal structures or business reorganisations, which have no other economic reason than to obtain such tax deferral, the operation could be seen as abusive and therefore be subject to strong penalties.
Thus, all of the above will imply that every and any type of operation, transaction, tax or business planning, business restructure or other corporate modification, will have to bring an explicit, or implicit but yet identifiable and demonstrable, business purpose and be performed under a credible economic rationale, with strict compliance to the general arm's-length principle.
Moreover, as it has been recognised among the experts, the only, or at least the most evident, way to sustain, prove, and justify the aforesaid conditions will have to be based on general TP methods in accordance to local regulation and the OECD guidelines, for which proper guidance and expert advice will become even more crucial.
Besides the above, article 41E is either referenced directly or linked indirectly by the tax reform a number of times. TP rules are considered in general to indicate when, how or why two or more parties should be considered as related parties for purposes of the new law (since they comprehend more and broader situations than other relationship rules within the ITL), or to show how a certain transaction or situation may be analysed by the tax authority to see if it complies with the arm's-length principle (becoming the basic legal tool for fiscal assessment).
However, the most recurrent, although indirect, reference to TP rules and its methods comes with the new procedures that regulate how the tax authority will be empowered to assess the allocation of profits arrangement that the taxpayers use to comply with the new core of the local ITL.
As anticipated above, the so called final taxes, (taxation at the level of local individuals or foreign taxpayers) could be deferred up until their income was effectively paid and received by them. With the elimination of the FUT, final taxpayers will be taxed over income on an accrued basis, meaning that local entities will have to perform a sort of upstream theoretical allocation of their profits among their owners or shareholders until they have been completely attributed to the final taxpayers, be them local individuals or foreign entities or individuals. This so called attribution of income shall be performed as agreed by the parties (shareholders or partners of a Chilean legal entity) under certain circumstances or in accordance to the interest they hold over the paid capital of the entity. However – and notwithstanding the method of attribution performed by the taxpayers – the tax authority will be empowered to assess such attribution/allocation in accordance to the TP methods stated in article 41E to remunerate the stockholders in accordance to their functions and activities in relation to the entity that is designating its profits.
Additionally, the Tax Reform Bill, considers two relevant direct changes to the local TP rules:
The tax reform modifies Article 41E of the Chilean ITL clarify that the local tax authority is empowered to assess any type of corporate or business restructuring process that is found to be removing or shifting from Chile to foreign countries any sort of tangible or intangible asset, or otherwise transferring an activity that could potentially have generated taxable income in Chile.
This assessment would be allowed when the tax authority is able to determine that the restructuring, with its embedded removal of assets or transfer of rights and the corresponding legal agreements or activities being performed for that reason, would have considered an arm's-length price, value or otherwise profitability, if it had been agreed upon non-related parties or when the price, value or profitability agreed, as a consequence of the restructuring, does not comply with said arm's-length principle.
Until now, according to the wording of the local ITL, business reorganisations would have been susceptible of tax assessment for an exit charge, if the transfer/shifting of assets and/or activities are moved to a tax heaven country.
Note that the Chilean IRS has pronounced an administrative interpretation of the current rule stating that it needs not to be a tax heaven, but the fact that the new law bill is including this express change would corroborate our restrictive legal interpretation of the current rule.
Penalty tax rate increased
The Tax Reform Bill modifies Article 21 of the Chilean ITL, which in turn will bring an increase from 35% to 40% rate for the penalty tax applicable in cases where the tax authority has determined a transfer pricing adjustment in accordance with the law.
Note that this rate could be raised to 45% in certain assessment cases if the taxpayer does not cooperate in due time and form with the fiscal investigation.