Central America post-BEPS: Potentially worrisome changes in the making

It has been two years since the release of the G20/OECD Base Erosion and Profit Shifting (BEPS) project. Numerous countries have recognised the importance of the BEPS project and have embraced the initiative. Panama and Costa Rica, the two largest economies of Central America in terms of foreign direct investments, have a BEPS agenda, for two very different reasons. Costa Rica because it decided it wanted to join the "big leagues" and become a full OECD member, and Panama because the country has been under enormous pressure from the OECD due its financial centre status. The other countries of the region, Guatemala, El Salvador, Honduras, Nicaragua and the Dominican Republic, have not started implementing BEPS in their domestic legislation. Nonetheless, all countries are using the initiatives as justification for domestic policies.

The BEPS initiative aims to modernise the international taxation framework without breaking any grounds as to its underlying principles. While the pre-BEPS international tax agenda pursued a system based on the single tax principle and promoted the avoidance of double taxation on cross-border income, the BEPS project, on the other hand, focuses on the antithesis by counteracting situations of double non-taxation through anti-abusive measures and by tackling harmful features of preferential regimes.

Implementation of the BEPS project, including the four minimum standards, is taking place within the so-called BEPS Inclusive Framework that has 100 members representing more than 93% of the global GDP and reflect a broad diversity of economic profiles and levels of development. The four minimum standards are Action 5 on fighting harmful practices, Action 6 on preventing tax treaty abuse, Action 13 on improving transparency with country-by-country (CbC) reporting and Action 14 on improving effectiveness of cross-border tax dispute resolution mechanisms.

The situation among the Central American countries is uneven. Panama and Costa Rica are the only ones that have joined the BEPS Inclusive Framework to implement the BEPS project. Panama's unique situation as a financial centre for Latin America and a global logistics hub, and Costa Rica's aspiration and ongoing process to become an OECD member, have undoubtedly created an impetus for these two countries to participate in the implementation of the BEPS project. The other countries are not yet really engaged but we believe this is merely a question of time. All told, the BEPS project along with its unprecedented media coverage worldwide have already produced an awareness on the matter, and four minimum standards are in turn having a growing influence on domestic tax policies and actions of the tax authorities in Central America.

This context raises many preoccupying questions: are the BEPS minimum standards adapted to the circumstances and needs of the region, are there any reasons to be worried about recent developments in Panama and Costa Rica, and what are the potential unintended consequences of BEPS in Central America?

Central American countries are not rich in non-renewable resources compared with other Latin American countries and they are not large suppliers of raw materials. The agriculture sector, with the exception of Panama, remains relevant in terms of employment and exports. These countries contribute to the global economy mainly with manufacturing activities (for example, textile in Honduras, El Salvador and Guatemala, medical devices in Costa Rica), services (for example, shared services centres across the region), tourism (Panama and Costa Rica), and finance (Panama and Costa Rica).

The recommendations of the BEPS project are not necessarily their main concern. Their economic reality is very different from the average OECD country. The Central America countries, which all follow the territorial tax system and have, except for Panama, a very limited double taxation treaty (DTT) network and have a specific base erosion agenda that requires addressing the following issues:

• Sourcing rules to be improved to protect their tax base;

• Transfer pricing;

• Taxation of cross-border services;

• Taxation of non-resident capital gains;

• Fiscal incentives; and

• Strengthening of the tax authorities and improvement of their technical resources.

The United Nations has addressed these issues for developing countries by providing recommendations in sync with their idiosyncrasies to ensure that they can strengthen their tax base and increase tax revenues. Yet the BEPS implementation has tremendous traction and some of the four minimum standards will have a profound impact in Central America.

Action 5 of the BEPS project is one of these because preferential regimes are an essential part of their economic fabric. Each country has some preferential regimes to attract foreign investments, create job opportunities and overall boost the local economy. They are strongly promoted and many of them provide tax benefits on income from geographically mobile activities, such as financial and other types of services, all of which are of interest to the OECD to counteract BEPS scenarios (i.e., Action 5: Counteracting Harmful Tax Practices).

Central American countries, and more specifically Panama and Costa Rica which have service-based economies, cater for multinational enterprises with headquarters, distribution centres and services, financing and leasing regimes, among others. These regimes have been explicitly mentioned in the 2015 BEPS Final Report of Action 5 and are within the scope and review of the Forum on Harmful Tax Practices (FHTP) in its mission of ensuring harmful features are addressed.

Despite the absence of public knowledge as to which regimes are currently being evaluated – besides those that to date have already been reviewed and rated by the FHTP, e.g. Panama's Colon free zone regime which was rated as an out of the scope -, it is expected that many preferential regimes promoted by Central American countries will undergo revision, some of which may require legislative amendments to address any inconsistency with the relevant BEPS minimum standards. Given the significant impact that preferential regimes have on these countries' economies, it is vital that they ensure consistency with these minimum standards to prevent adverse repercussions (e.g. blacklisting, application of discriminatory measures).

In the same vein, Action 13 on Transfer Pricing Documentation and CbC reporting entails multiple challenges for the region. In implementing this minimum standard, the Central American countries will need to have regulations in place for CbCR, regardless of whether they have MNEs located or operating in their jurisdiction.

In this regard, it is likely that Central American countries will need to undergo legislative process in order to make necessary adjustments in their respective domestic legislation. Challenges to be faced when trying to meet the OECD and treaty partners' expectations will include data confidentiality and safeguards, implementation of adequate IT systems and administrative infrastructure. The administrative and financial burden for these jurisdictions of meeting the Action 13 standard will be significant. The peer review documents on Action 13 actually acknowledge the issues that developing countries will face and have proposed remedies in order to assist these jurisdictions in their transition to implementing this action. Unfortunately, countries like Costa Rica, in their eagerness to be compliant with whatever the OECD proposes, seem to be underestimating the potential complexities and negative effects on their own internal economy that the implementation of these initiatives will have.

Furthermore, there are other initiatives taken by the OECD in BEPS-related matters that differ from the 15 Actions of the BEPS Package and that may be of interest to the Central America countries and other emerging countries. This is the case of the international VAT/GSL guidelines, which in a nutshell address issues that arise in jurisdictions from the uncoordinated application of VAT to international transactions. It is likely to pique the interest of those jurisdictions that have a territorial tax system and that are prone to having their tax base eroded in the context of international trade.

Until now, Panama and Costa Rica are the only two countries in Central America that have expressed their commitments to the BEPS initiative and more specifically to at least the four minimum standards.

Panama has made several developments in the international taxation landscape which have been crucial for the country's positioning as a more compliant jurisdiction in line with international standards and expectations. Panama joined the BEPS Inclusive Framework on October 31 2016. In this regard, Panama plays a part in the decision-making process of any changes or initiatives submitted by the OECD to the members on BEPS.

Moreover, Panama has expressed its intent to sign the Multilateral Instrument (MLI), which as of today would impact 17 DTTs of the country's treaty network. There is no information available regarding the reservations that the country would make on some of the provisions of the MLI.

Regarding Action 5, Panama is being reviewed by the OECD Secretariat in order to address harmful tax practices. There is only information available regarding one preferential regime that has been reviewed, i.e. the Colon free zone which was considered out of scope. However, Panama offers other preferential regimes that could undergo an FHTP review, specifically those that provide tax benefits in headquarters regimes, distribution and service centre regimes, banking and financing regimes.

Regarding transfer pricing matters, the Panamanian tax authorities recently made a public consultation on a draft bill which would introduce advance pricing agreements (APA) in Panama for the first time. It would be a game changer for Panama if this bill were to go through and it would be attractive to MNEs.

There are other actions of the four minimum standards that Panama is committed to implementing, such as CbC reporting, but the tax authorities have not to date laid out any plans in this respect. That said, Panama modified in October 2016 its transfer pricing documentation rules which are now aligned with master file requirements. Some of the aspects that the country would have to consider regarding CbC reporting is whether it will sign the multilateral competent authority agreement or instead go for the bilateral route, similar to what it did with the common reporting standard.

Costa Rica's accession process to the OECD has been ongoing since 2015. It is the fourth Latin American country to pursue OECD membership, following the path of Mexico and Chile, and Colombia which is currently in the approval process. In August 2016, the tax authorities established a BEPS commission to work on a domestic regulatory framework to implement the BEPS Action Plan.

Costa Rica signed the MLI in June 2017. It will impact the DTTs with Spain and Germany. It has opted for the application of the principal purpose test alone and no reservations were made on other anti-abuse provisions such as those related to dividend transfers and permanent establishments situated in third jurisdictions. Also, no reservations were made on the permanent establishment and commissionaire arrangement provisions.

A significant tax bill, referred to as the Law on the Strengthening of Public Finances, was released in August 2017. It contains a new income tax law and a VAT law that would replace the existing sales tax law. This bill triggers some BEPS related issues and highlights the influence of the BEPS project as the country is considering implementing some changes that go beyond the minimum standards, such as:

• Limitations on interest and financial expense deductions. The proposed rule provides a deduction cap within a suggested band of 10-30% of EBITDA. The issue being tackled by the bill is addressed by BEPS Action 4 (Limiting Base Erosion Involving Interest Deductions and Other Financial Payments) but it is not a minimum standard. Applying a uniform threshold across industries without taking into consideration sector specifics could have negatives consequences for the economy. This demonstrates how in their pursuit of recognition by the OECD, local authorities lack either a true understanding of how these measures affect the domestic economy or they are simply disregarding their effects.

• Controlled foreign companies rules in relation to passive income.

• Hybrid mismatch arrangements. The provision incorporates BEPS recommendations of Action 2 which is not a minimum standard. This seems like a strange proposal since the use of hybrid instruments in general is not common in the region.

In respect of transfer pricing, Costa Rica has not officially said how it would implement CbCR but the ongoing accession discussions to the OECD indicate it should just be a question of time. Having said that, the country to date does not even have the minimum requirements to implement domestic transfer pricing rules. It lacks technical expertise and training, it does not have the right tools, databases of comparables and infrastructure and it technically does not even have a formal law regulating transfer pricing. There is only one decree issued by the executive branch in 2015 but the law to be approved by the legislative branch that ranks higher in the hierarchy of norms is still to come. This is a country that started auditing and challenging transfer pricing domestically when it did not even have a single rule or authority beyond a stretched interpretation of the substance over form principle to justify its assessments. This illustrates the weakness of the legislative process in Costa Rica and the difficulties in making new laws, which translates to legal uncertainties for taxpayers in a jurisdiction that has traditionally been known for its stability and high legal standards.

The BEPS project, which is now being implemented at great speed, will effectively eliminate certain BEPS practices of MNEs. It will have a major impact on how these MNEs operate worldwide, with their supply chains, research and development, financings and corporate structures being inevitably impacted. Viewing this situation through the lens of local realities in Central America gives a contrasting picture and we see some unintended and possible worrisome consequences.

Firstly, to be effective, BEPS calls for significant local adjustments and harmonisation that the governments and tax authorities in Central America are not in a position to handle, due essentially to a lack of resources and technical expertise. This will undoubtedly trigger uncertainties and contradictions in respect of positions adopted by taxpayers, which in turn could even cause extreme cases of triple-taxation. The relationships between tax authorities and taxpayers in Central America are already conflictual, and tinted by broad cases of abusive collection practices from the authorities will become more so, leading to increased tax controversy. The criminalisation of tax matters and the rule-of-law violations we have recently observed specially in Guatemala or various cases in Costa Rica are likely to only get worse. The priority of the region should be in the strengthening of the local institutions and not the bullying of taxpayers which undermines the business environment.

Secondly, BEPS calls for the leveling of the playing field among countries that are part of the Inclusive Framework which requires a consistent implementation of the four minimum standards. The reality of Central America is a need to attract investments to create economic growth and employment. How will local governments reconcile their macroeconomic objectives with a need to reform their tax incentive regimes? The answer is yet to come. Each of these countries is very different to one another, and it will be really challenging for these low-income jurisdictions to maintain their competiveness and also implement these OECD soft law instruments.

Rafael Sayagues

Managing Partner – Tax & Legal Central America – Panama – Dominican Republic EY Central America Tel: +506 2208-9880 Mobile: +506 8830-5043 rafael.sayagues@ey.com Rafael is one of the founders of EY in Central America. He is the Tax and Legal Managing Partner for EY in Central America, Panama and the Dominican Republic based in Costa Rica and part of the International Tax Services Latin American Business Center (LABC) group in New York. He is also part of the Transactions Advisory Services (TAS) team. Rafael has over 26 years of experience in local and international tax planning, design and implementation of cross-border transactions, corporate restructurings and reorganisations, mergers and acquisitions, financing and investment structures, project financing, transfer pricing and supply chain planning, design and taxation of shared services centers, international trade and tax incentive systems for free trade zones, and overall cross-border taxation in the Central America region. He is also a member of the Family Business group that specialises in advisory services to family in areas such as estate planning, asset protection, international tax compliance, corporate governance and structuring. In 2011, 2012, 2013, 2014, 2015, 2016 and 2017 he was ranked as a leading Band 1 lawyer in Corporate / Tax by Chambers Latin American Guide. He is a member of the International Bar Association (IBA), International Fiscal Association (IFA), the American Bar Association (ABA) and the Costa Rican Bar Association. He is also a member of the Young Presidents Organisation (YPO), Costa Rica Chapter. Rafael has an LLM in tax from the University of Florida, a JD and undergraduate degrees from the Universidad de Costa Rica.

Isabel Chiri

Senior Manager – Tax Central America – Panama – Dominican Republic EY Central America Tel: +507 208-0112 Mobile: +507 6227-6598 isabel.chiri@pa.ey.com Isabel is a senior manager in Central America, Panama and the Dominican Republic in the International Tax practice. Her primary focus is international tax matters, double tax treaties, exchange of information agreements, the Global Forum's peer review process and BEPS matters. Isabel has over 10 years of experience in international taxation as well as local tax advisory in Central America and Peru. She joined EY in 2010. Prior to that she worked with Peru's Minister of Finance and was part of the team in charge of international taxation issues and double tax treaties. She also participated in the negotiations of Free Trade Agreements and tax reforms. She served in the Peruvian Tax Court as principal adviser. Isabel was also a Lecturer in tax law for several years in the Catholic University, Peru. Isabel has an LLM in International Taxation from Levin College of Florida University. Fulbright Scholarship (2010). She also has a Bachelor's degree in Law from the Catholic University in Peru.

Alexandre Barbellion

Senior Manager – Tax Central America – Panama – Dominican Republic EY Central America Tel: +506 2208 9880 Mobile: +506 8834-6395 alexandre.barbellion@cr.ey.com Alexandre is a senior manager in the tax practice in Central America, Panama and the Dominican Republic. His experience with EY in Central America started in 2002-2005 and resumed in 2013. He currently coordinates the Family Business and Family Office initiatives in Central America. Alexandre is a tax and corporate lawyer with over 15 years of experience in tax and wealth planning, trusts and private foundations, asset protection, transactions (acquisitions and divestitures, reorganizations, joint ventures and financings). Alexandre has a Juris Doctor equivalent in business and tax law from Panthéon-Assas University in Paris. He also has an LLM (Master of Laws) from Northwestern School of Law and a Certificate in Management from the Kellogg Graduate School of Management. He is a certified Trust and Estate Practitioner (TEP) of the Society of Trusts and Estate Practitioners (Advising Families Across Generations) and a member of the Family Firm Institute.