Government Changes Anti-Tax Avoidance Bill

Introduction
Income Tax and General Tax Compliance
Interest Paid to Related Foreign Financial Institutions
General Tax Compliance

Introduction

In August 2000 the government submitted its Anti-Tax Avoidance Bill with proposed amendments to existing tax laws. The bill implements the anti-tax avoidance campaign. The bill was amended by the government in December 2000 and January 2001 with the purpose of resolving difficulties that were raised by the opposition party and the public, particularly in relation to the new thin capitalization rules and the date of enforcement of the new tax provisions. The bill was approved by the Lower Chamber of Congress on January 17 2001 and is awaiting Senate approval.

According to government statistics there is an annual 24% tax evasion rate, which amounts to approximately $4 billion. The bill aims to reduce this rate by around 20% annually until 2005. The bill forms part of the reform package that will finance social programmes such as the Growth with Equality Programme, part of President Lagos's 1999 presidential campaign. Another of the bill's aims is to collect $800 million annually until the end of the president's term of office.

The proposals aim to:

• improve tax collection and scrutiny by the authorities;

• amend current legislation to close loopholes of tax avoidance and elusion;

• modernize and promote efficiency in governmental tax agencies; and

• ensure that taxpayers receive fairer treatment by the authorities.

Income Tax and General Tax Compliance

The main issues of interest to foreign companies with subsidiaries or investments in Chile concern proposals that deal with income tax and general tax compliance and procedures.

Income tax
Foreign institutional investors (eg, mutual and pension funds) will be exempt from taxes on capital gains arising from (i) the sale of shares of open stock corporations traded on the stock exchange, and (ii) the sale of bonds issued through any mechanism authorized by the Securities and Insurance Superintendency or by the Central Bank of Chile, the state of Chile or Chilean corporations (within Section 25 of the Securities Market Law).

Foreign institutional investors must comply with a wide range of rather impractical requirements in order to benefit from the exemption.

Real estate tax will no longer be credited against income tax, except in agricultural matters.

According to the bill, as of December 31 2000, restriction in the use of tax losses will not be available when a company that registers such losses from previous years is subject to a direct or indirect change in ownership of at least 50%, and one of the following occurs:

• In the 12 months before or after the change in ownership, the company changes its scope of business (eg, by offering new corporate services). The new text of the bill adds the phrase "unless it maintains its principal business purpose". This would effectively admit the use of tax loss carry-forwards even when the company expands its scope of business, provided it maintains its main business purpose;

• At the moment of the change of ownership, the company does not have capital goods or other assets that are proportional to the price or consideration payable for the acquisition of company shares; or

• The company is transformed into a holding company and its revenue is originated solely by its participation in other companies.

This restriction does not apply when the change of ownership is made among related companies. Article 100 of the Securities Market Law defines 'related companies' as:

• those belonging to the same entrepreneurial group of companies;

• subsidiaries, parent and sister companies; and

• those that control 10% or more of the capital or voting capital, or can appoint at least one director or member of management in the other company.

For assets subject to depreciation as of 2000, the bill proposes that accelerated depreciation will be deductible as an expense only for calculating corporate tax. For the purpose of determining the retained taxable earnings subject to withholding or personal taxes, only expenses up to the normal depreciation would be deductible. This will determine that companies will have higher retained taxable earnings, without a credit for corporate tax, on the difference between normal and accelerated depreciation.

Currently, when profits are reinvested into shares issued by a publicly traded local stock corporation, the taxpayer cannot avoid paying the taxes that would have affected the withdrawal of profits if the shares were subsequently sold at tax cost (even when generating no capital gains). The stock corporation must maintain records containing the information regarding the taxpayer and the tax profits reinvested to ensure payment of the tax. The bill proposes an extension of these rules to all stock corporations, including those that are neither listed nor publicly traded.

The original bill introduced a limitation to deduct interest paid to foreign creditors as an expense for tax purposes, when the debt-to-equity ratio of the taxpayer exceeded 3:1 (the so-called 'rejected expense' rule). This restriction would be applicable when such debt qualified for the reduced 4% withholding tax rate on interest payments (instead of the general 35% withholding tax rate) remitted abroad to non-domiciled and non-resident creditors. Currently a 4% withholding tax rate applies to interest paid to foreign banks or foreign and international financial institutions, provided that the latter are duly registered at the Central Bank and that the Central Bank has previously approved the foreign loan. The rejected expense rule has been dropped from the original bill. A variation of the 3:1 thin capitalization rule has been used to determine the withholding tax rate that applies to interest payments remitted abroad.

Interest Paid to Related Foreign Financial Institutions

The original bill proposed a very restrictive definition of 'foreign financial institution', thereby limiting access to the reduced 4% withholding tax on interest payments remitted abroad to such entities. The proposed restrictive definition has been deleted from the bill.

A new rule has been introduced to apply 35% withholding tax on interest payments remitted abroad to related creditors. The main features of this new rule are that the 35% tax would be applied only to interest on 'excessive debt' owed to related parties, and that excessive debt occurs when total debt exceeds three times the debtor's equity (the so-called '3:1 debt-to-equity' ratio).

The problems of this rule are that:

• there is no definition of 'total debt';

• the new definition of 'equity' does not add back tax losses; and

• the wording of the new rule is confusing with respect to which interest payments are subject to 35% tax.

There is no so-called 'grandfather' rule. Therefore, if enacted, the new rules would apply to interest to be paid with respect to all loans. The situation regarding accrued but unpaid interest is unclear. It is recommended that interest should not be affected by the new rules.

Confusingly, the rule would also apply to interest paid abroad on bonds when the bondholder is a related party.

General Tax Compliance

In cases concerning a tax dispute with the Internal Revenue Service (IRS) the collection of taxes will be suspended until the trial ends, provided that guaranties (collateral or seizure) are granted by the taxpayer and are deemed to be sufficient to the IRS.

The government has committed to restructuring the administration of justice on tax disputes within six months, as a response to criticism of the current system whereby the judge at first instance is an employee of the IRS.

According to the proposals, the IRS will be able to oblige taxpayers to file tax returns and make payments of taxes via the Internet.

The contents of the bill may vary before enactment. In fact, the text approved by the Lower Chamber varied significantly from the original text on several key issues. The bill is expected to be amended by the Senate in several aspects. If so, the new text of the bill (as approved by the Senate) must be submitted to a joint commission of representatives from both the Lower Chamber and the Senate. This third stage is expected in April or May. Final enactment is expected during the first semester of 2001.

For further information on this topic please contact Ricardo Escobar or Bárbara Vidaurre at Carey y Cía by telephone (+56 2365 7216) or by fax (+56 2633 1980) or by e-mail ([email protected] or [email protected]).