Enduring appeal: A flexible framework for free trade zones has paid dividends

If it were not for its history of crime and security issues, Colombia would likely be at the top of regional ease-of-doing-business rankings. Reforms implemented over the past 15 years have created an open environment conducive to an expanding private sector. One of the mechanisms for stimulating this expansion has been the implementation of a liberal legislative framework for the establishment of free trade zones (FTZs) around the country.

BACKGROUND: As of June 2013 Colombia had 106 FTZs – 33 permanent and 73 specialised – while figures from the end of 2012 showed a total of 3.9m sq metres in FTZs. That is expected to rise, with already approved FTZs coming on-line by 2014 set to bring the total to 9.25m sq metres of real estate. Edgar Orlando Martinez, the executive director of the Chamber of FTZ Users in the National Association of Entrepreneurs, outlined the impact FTZs have had. “They have been a key mechanism for attracting investment, promoting economic growth in non-conventional areas, promoting technology and formalising the economy.” However, the system faces obstacles, including a lack of connectivity in the interior, while there may yet be a problem if competitiveness drops as a result of diminishing benefits or even oversupply.

FRAMEWORK: Though a legislative framework for FTZs has existed since the passing of Law 7 in 1991, they only took off when Law 1004 of 2005 was passed. “Since the 2005 reform, FTZs have been large recipients of foreign investment and their number has grown. FTZs generate significant income and exceeded $9bn in investments, creating nearly 150,000 direct and indirect jobs and contributed $10.8bn in tax between 2006 and 2011,” said Juan Pablo Rivera, president of Zona Franca de Bogotá. The primary change to the existing regulation was the elimination of the requirement that firms export at least 75% of their production, thereby opening up the possibility for local companies to relocate and operate from FTZs. Additionally, the previous 0% tax on profits was replaced with a 15% rate, which still compared favourably to the 33% corporate tax on profits in place for companies located outside FTZs at that time. Following tax reform (see analysis) in 2012, the rate has again increased but will only apply to FTZs established after December 31, 2012. These FTZs will be required to pay the standard 15% income tax as well as an additional equity income tax of 9% from 2013 to 2015 and 8% thereafter.

Law 1004 also introduced a new concept by allowing individual companies of sufficient size to launch as a proprietary FTZ, so-called specialised FTZs. The results of the 2005 reform are clear. Before Law 1004 of 2005 the country had just 11 permanent zones, 10 of which were dedicated industrial parks. After its implementation, this had increased to 30 permanent zones, 71 specialised zones and three enlarged zones as of October 2012.

REQUIREMENTS: FTZs are split into two categories: specialised and permanent. The requirements for establishing an FTZ vary by type. To obtain a declaration for a permanent zone, which contains multiple companies, a new company with at least $7.2m in assets must be established. Secondly, within five years the FTZ must be host to a minimum of five companies, and during this time the operator must make an investment of $14.5m. The final requirement is that the zone must have an area of at least 20 ha.

Companies wishing to establish operations in existing permanent zones must comply with employment and investment generation requirements in accordance with their revenue. Within three years companies with assets of $163,750-1.6m are obliged to create at least 20 new jobs, though firms of this size are not held to any investment requirements. Companies with assets of $1.6m-9.8m must invest a minimum of $1.6m and create 30 jobs within three years, while those with annual revenues of more than $9.8m must create 50 jobs and invest at least $3.7m.

The requirements for specialised or single-company FTZs differ from permanent FTZs and are more extensive. Companies must comply with investment and employment generation requirements regardless of income, meaning the specialised zones are generally designed for larger firms making substantial investments. Within three years companies that have established themselves in a specialised zone must make investments equal to 150,000 monthly minimum salaries (the minimum monthly salary for 2013 is $354) and hire 150 new employees.

Applicants must also draft, file and obtain approval for a business plan (referred to as the master plan for general development of the FTZ) containing feasibility studies. Operations and activities must also be performed exclusively within the FTZ. Finally, firms establishing a FTZ must set up a new company, with exemptions granted only in special cases.

INCENTIVES: In addition to reduced income tax, companies based within FTZs benefit from several other incentives, such as the exemption from value-added tax. Companies are also not required to pay taxes on capital, commodities or waste. Importantly, as FTZs are technically not considered to be within the country, exports originating in FTZs are also tariff-free. Likewise imported merchandise and commodities used in the manufacturing of exports are allowed to pass through Customs duty free.

FLEXIBILITY & DIVERSITY: One of the strengths of the FTZ regulations is the flexibility they provide, which allows a range of geographic areas and industries to benefit from various incentives. Jorge Eduardo Salamanca Gallo, the managing director of Zona Franca Metropolitana, told OBG, “The common perception of FTZs is that of a typical industrial park, but the reality can be quite different. In countries such as Japan, FTZs could also constitute a train line or a specific highway, and Colombia is starting to move closer to that more flexible model.”

FTZs already contain various businesses, including hospitals and schools, all of which receive the benefits associated with being located there. The effect of FTZs on economic growth is difficult to quantify, but they most certainly have had a noticeable impact across several sectors. Companies from a range of industries, including industrial manufacturing, textiles, business process outsourcing (BPO), software and IT services, logistics, agribusiness and metallurgy, among others, are all located within the myriad FTZs in the country.

Economic development is widely spread throughout Colombia. While Bogotá remains the business and financial capital, a number of large secondary cities are home to a variety of industries (see analysis). Accordingly, permanent and specialised zones have been established all over the country, with the exception of the Amazon basin, due to its small population. Though the flexibility of FTZs allows for companies to establish themselves in just about any region and provides access to the local market, common traits are shared with other coastal countries regarding the location of FTZs. Dividing Colombia into four regions (Caribbean, Andean, Pacific and Western), the largest concentration is found along the northern coast, with 12 of the 33 permanent zones in the Caribbean region.

Moreover, of the current 3.9m sq metres of space in FTZs, over half is found along the northern Caribbean coast in the departments of Magdalena (1.3m sq metres), Atlantico (570,000 sq metres) and Bolivar (560,000 sq metres). This is primarily due to the ease of exportation from these areas given their many ports, and as a result there is a high concentration of manufacturing firms in this region.

The Andean region features nine FTZs, including the Bogotá FTZ, which has more than 220 companies and is located next to the capital’s international airport. Many companies based in permanent or specialised zones in and around the capital tend to be in technological or service-oriented industries such as BPO. The regional and global connectivity offered by Bogotá has also attracted the likes of numerous storage and logistics firms, while recent growth in the construction industry has been a magnet for companies manufacturing construction materials for domestic consumption. Juan Gabriel Pérez, the executive director of Invest in Bogotá, told OBG, “Bogotá’s economic vocation has transformed from being a traditionally industrial city to increasingly becoming a domestic services hub. More than 70% of financial transactions in the country take place in Bogotá. Despite that, the city maintains a strong manufacturing core, with expertise in plastics, mechanics and vehicle assembly, among others.”

The Western region features six permanent zones and is home to the country’s second-largest city, Medellín, and its coffee industry. As a consequence, the region has a growing service industry. However, agribusiness, textiles and other manufacturing-related sectors have also benefitted from the permanent FTZs. Lastly, the Pacific region hosts the other six FTZs, the city of Cali and Buenaventura, which is home to two of Colombia’s principal Pacific ports. Like their coastal Caribbean cousins in the north, permanent zones in the Pacific region have attracted manufacturing and logistics firms, though agribusiness and BPO have also taken an interest.

CHALLENGES: While foreign and domestic firms alike have capitalised on the advantages FTZs offer, several problems threaten to slow the pace of development. Jorge Cardona Laverde, the general manager of Intexzona, told OBG, “The considerable freedom to establish FTZs has sparked a real estate boom. The country will soon have more than 110 FTZs, a figure which, if it continues to expand, could actually pose a risk of oversupply.” If oversupply becomes a reality, its negative effects, such as reduced competitiveness, could be felt in the short term, with the total area occupied by FTZs expected to nearly triple by 2014. One solution touted to avoid the issue of oversupply is to specifically promote and approve permanent FTZs that are specialised in certain industries. The creation of such dedicated cluster-like zones is typically driven by a real source of demand, whereas more generalised, all-purpose permanent zones have the luxury of taking on slightly more risk due to their flexible nature.

IMPLEMENTATION: Additional problems have been reported in the implementation of regulations. “Despite a relatively strong legislative framework and the stability of the standards over the past four years, the Tax and Customs Authority remains unbalanced in the interpretation of some rules related to FTZs,” Carlos Mesa, the managing director of Zona Franca Río Negro, told OBG.

A proposed alteration to legislation for companies not operating in FTZs could also affect competitiveness, as the government is currently considering the import requirements for firms operating under regular national law. The normal Customs regime requires companies to register all imported products within one month, with the potential change extending that deadline to one year, which would limit the FTZs’ advantage of bypassing the process entirely. Finally, a lack of interconnectivity within the country has limited the ability of firms to fully access the domestic market, an issue that is not restricted to companies located within FTZs.

FTZs have been a boon to the economy, helping to create an investor-friendly business environment, and exports coming from FTZs have been growing at astounding rates, at times higher than 50% annually. They have also had a positive impact on helping to formalise the large informal economy, as well as promoting growth in non-conventional areas and sectors. According to Martinez, 42,000 new jobs have been created since the regulatory reform of 2005. Though the FTZs face challenges, improved security and steady macroeconomic growth point towards Colombia being an increasingly attractive investment destination, with the zones primed to play a key role in converting interest into investment.