Reformed tax framework in Colombia presents challenges in the sector

In Colombia a change of government often precipitates a tax reform. During his presidential campaign President Iván Duque acknowledged that the tax burden of corporate taxpayers was too heavy, and promised to reduce it as a means of fostering investment and productivity. To counter the reduction in corporate income tax collections, the government proposed to apply value-added tax (VAT) to all goods and services, including those deemed necessary to cover basic family needs, while also creating a refund mechanism to prevent the measure harming low-income families.

In the event, however, Congress did not accept the modification to VAT and started proposing alternatives to raise the taxes that were needed to fill the hole that would be left by the reduction of the corporate income tax rate. Some of these alternatives were finally approved.

In the end the 2018 tax reform, which in its original version was coherent and well articulated, ended up being somewhat patchy. The new taxes are not enough to cover the tax cut, and in addition they are temporary, generating uncertainty as to what will happen when they expire. Now it is the government’s turn to make ends meet. Spending must be reduced, and evasion and informality must be fought quickly and decisively.

With regard to reducing informality, the key areas that the government must focus on are modernising its technology and re-dimensioning its workforce. Initial steps are being taken with the adoption of electronic invoicing, but several other tools must be adopted and the tax office’s team trained to use them.

Some of the most relevant changes that the 2018 reform implemented fall into the following areas.

Reduction of Corporate Income Tax

The 2016 tax reform (Law No. 1819) reduced the corporate income tax rate to 33%, but left the tax rate at 34% for 2017, and created an income tax surtax of 6% for 2017 and of 4% for 2018. The 2018 tax reform (Law No. 1943) confirmed the 33% income tax rate for 2019 and did not create any surtax. Pursuant to the law, the 33% rate will be reduced to 32% in 2020, 31% in 2021 and 30% in 2022. As an exception, financial entities will be subject to a corporate tax rate of 37% for 2019, 35% for 2020 and 34% for 2021.

Presumptive Income Minimum Tax

A corporate taxpayer may be required to pay income tax on its presumptive income, which is an alternate minimum taxable income, if its ordinary income in a given year is lower than its presumptive income. Presumptive income is equal to 3.5% of net worth as of December 31 of the preceding tax year.

The rationale for having a presumptive income tax is twofold: first, it is aimed at ensuring that taxpayers who own given means of production use them productively for the benefit of the country; and second, it guarantees that the state will always receive a minimum tax from these taxpayers.

However, this reform has come in for criticism, with some arguing that it is not appropriate to impose an additional burden on companies that, for different reasons, are not making a profit. Moreover, presuming productivity of 3.5% when the economy is growing at a slower rate may be construed as unreasonable.

This is why, for the years 2019 and 2020, Law No. 1943 reduced the percentage that must be applied by a taxpayer on its net worth to calculate its presumptive income from 3.5% to 1.5%. Law No. 1943 also establishes that, as of 2021, that percentage shall be 0%.

Thin Capitalisation Rules

Colombia’s thin capitalisation rules restricted the deduction of interest paid on loans obtained from related or unrelated parties, resident or non-resident, if the loans exceeded a 3:1 debt-to-equity ratio when compared to the taxpayer’s net worth at the end of the preceding year. The new law eliminates the thin cap limitation on loans obtained from unrelated parties but reduces the debt-to-equity ratio on loans from related parties to 2:1.

Alongside this, Law No. 1943 creates a requirement for the deduction of interest obtained from unrelated parties. It establishes that, if required by the tax authority, the taxpayer must submit a certification, issued under oath by the lender, that the loan is not a related-party loan granted through a guarantee or a back-to-back structure, or any other transaction in which the related party acts as the creditor.

Moreover, the law states that the third-party lender may result joint and severally liable with the debtor if it accepts an operation that is intended to cover a related-party loan. From a practical perspective, it may prove difficult for a taxpayer, under any circumstances, to obtain a certification issued under oath by a financial institution; and if the taxpayer is not able to obtain the certification, they will be putting a legitimate deduction at risk. Indeed, making the allowance of a deduction rely on a certification issued by a third party may be unconstitutional.

Real Fixed Productive Assets

Generally, VAT systems allow taxpayers to credit any VAT that they pay in relation to a VAT-liable activity; this includes VAT paid on the acquisition of fixed assets ( machinery, equipment, real estate, etc.). However, that is not how the Colombian VAT system works: VAT on the acquisition of fixed assets cannot be credited but must be capitalised as part of the acquisition cost of the assets, for further depreciation.

Law No. 1949 authorises that taxpayers who acquire real fixed productive assets credit the VAT paid on their acquisition against their income tax payable of the year in which they acquire the assets, or subsequent years.

The law does not define real fixed productive assets. In the past, for a different purpose, regulations defined them as tangible assets that the taxpayer acquires for maintaining them in its equity, that participate directly and permanently in its income-producing activity, and that are depreciated or amortised for tax purposes. It is not clear if the government plans to stick to a definition along these lines or create a different one for the new benefit.

Changes to Dividend Tax

The tax on dividends distributed to non-resident entities was increased from 5% to 7.5%. In addition, a dividend tax at the same rate of 7.5% was created for the first distribution of dividends between companies inside Colombia, if those companies are not part of a business group (grupo empresarial) or subsidiaries of a Colombian holding company.

The dividend tax is not supposed to burden a Colombian company that receives dividends from another Colombian company, but rather the shareholder who ultimately receives the dividend, be they a Colombian individual or a foreign non-resident shareholder, so this final shareholder would be entitled to credit the tax that was withheld in the first dividend distribution.

This would seem to mean that if the final shareholder is resident in a state with which Colombia has a double taxation treaty in force that eliminates the tax on dividends, the withholding should not apply; it would also mean that if the withholding tax rate under treaty rules is lower than 7.5%, the withholding should be limited to the treaty rate. However, the rule is not clear and different interpretations may exist.

Wtihholding Tax On Payments Abroad

There are several modifications to the withholding tax rates on payments made to non-resident parties (see table). As has been observed, most of the withholding tax rates were increased. Special attention should be paid to the increase in the management and direction fees paid to foreign related parties, as the increase in the withholding will certainly result in a heavy burden on multinational firms, which in addition may have difficulties crediting the withheld amounts when the services are rendered from their place of residence.

While it is important to avoid charges that may erode the taxable base of Colombian taxpayers without justification, the fact is that multinational firms need to incur centralised management expenses. Imposing withholding taxes on management expenses incurred abroad will result in uncreditable withholding taxes for said firms, and will make global operations difficult. Transfer pricing, exchange of information and tax auditing may be a more reasonable approach to confronting base erosion.

Permanent Establishments

Until 2018, permanent establishments (PEs) were subject to Colombian income tax only on their Colombian source income. This meant that the existence of a PE, and of income attributable to said PE, did not necessarily generate taxable income for the PE. Law No. 1949 corrects this situation by establishing that PEs are now subject to income tax on their worldwide income.

Law No. 1949 also establishes that interest attributed to a PE is only deductible if it has been subject to withholding taxes. This could result in the disallowance of all the interest attributable to a PE, considering that, generally speaking, attributed interest is not subject to withholding taxes. In effect, although there is a rule pursuant to which these kinds of limitations are not applicable if the transaction is subject to transfer pricing regulations, the applicability of this rule to the case under comment is unclear.

Taxation of Indirect Transfers

As of the enactment of Law No. 1943, the indirect sale of (i) shares in Colombian companies, or (ii) rights or assets located in Colombia through the transfer of shares, participations or rights in foreign entities, shall be taxed in Colombia as if the underlying Colombian asset had been sold by the foreign investor that directly holds the Colombian investment (i.e., by the direct owner of the underlying Colombian asset). For this purpose:

• The determination of the applicable tax rate (33% or 10%) and tax (income tax or capital gains tax) would depend on the term during which the direct investor in the Colombian asset owned said asset.

Note that the law does not address specifically how the ownership term should be counted when the direct investor acquired the Colombian asset derived from a merger operation; however, in our view, based on the provisions of Article 319-4 of the Colombian Tax Code, if a merger is tax neutral, there are legal grounds to state that the ownership period should be counted from the date in which the absorbed company acquired the Colombian shares, and not as of the date in which the merger took place. Nor does it address what should happen when, after the first shares have been acquired/received, the direct investor increases its investment through capital or cash contributions. Nevertheless, by applying general interpretation rules it should be concluded that when this occurs, the direct shareholder (and thus indirect shareholders) would have several groups of shares over which a separate analysis should be made to determine the tax applicable (income tax or capital gains tax).

• Profits derived from the transaction would correspond to the positive difference between the direct Colombian investor’s tax cost in the underlying Colombian asset and its commercial value.

• Special tax treatments or conditions that would apply upon disposal of the underlying Colombian asset by the direct Colombian investor must also be considered when determining the tax due in an indirect sale scenario.

• There are two exceptions in which the indirect transfer rules should not apply: (i) when the shares that are being transferred are listed in a stock market that is recognised by a governmental authority and has an active secondary market, and when no more than 20% of the shares are concentrated in the same real beneficiary; and (ii), when the value of the assets located in Colombia that are being indirectly transferred represent less than 20% of the book value and of the market value of the total assets of the foreign entity that is being transferred.

New Holding Companies Regime

The law creates a holding regime similar to those that exist in Spain and elsewhere. In a nutshell this regime would mean dividends obtained by a Colombian holding company (CHC) from investments held outside of Colombia, as well as gains obtained from the sale of said investments, are not subject to Colombian income, capital gains or dividend taxes. It would also mean that gains from the sale of the shares of a CHC are not subject to income or capital gains tax on the part that corresponds to its participation in investments held outside of Colombia. To qualify as a CHC, a Colombian entity should have participated directly or indirectly in at least 10% of the capital of two or more resident or non-resident entities for a period of at least 12 months. It should also have the human and physical resources required to operate. These requirements are deemed to be met if the entity has at least three employees and its own address in Colombia, and it should be able to demonstrate that the strategic decisions for operating its investments are taken in Colombia.

The Orange Economy

The new law also addresses questions related to tax benefits. A key area in this regard is the creative economy.

The government is committed to fostering the creative economy in Colombia. As is the case in other countries around the world, the central pillars of the creative economy, which President Duque and a colleague dubbed the “orange economy” in a book they published in 2013, are creativity, culture, art and technology.

Companies in the orange economy may be exempt from corporate income tax for a period of seven years, counted from the moment in which their project is accepted by the Ministry of Culture. For this purpose they need to meet the following requirements: i. They need to be incorporated before December 31, 2021; ii. Their economic activity must fall within at least one of the different categories of activities that are listed in Law No. 1949; iii. They must be domiciled within Colombian territory and their exclusive activity should be the development of added-value technological or creative activities; iv. They must have the number of employees that the government dictates, which cannot be fewer than three; v. They must have their project approved by the Ministry of Culture; and vi. They must make an investment of at least 4400 units of tax value (UVT), equivalent to approximately COP151m ($51,600), in a maximum period of three years. The programme that the government is creating around the orange economy is sound and ambitious. Several governmental entities are working together to make it successful. The tax incentive is just one part of the programme.

Agriculture Sector

Law No. 1949 grants a tax exemption of 10 years on income that increases the productivity of the agriculture sector. In order to be eligible for this benefit, the taxpayer needs to comply with the following requirements: i. The company must be incorporated and have its headquarters within the territory in which it will make the investments that are going to increase productivity; ii. The company must have as its exclusive business purpose the development of agricultural activities that will increase productivity; iii. The company must be incorporated before December 21, 2019; iv. The company must hire the minimum number of employees required by the government, which cannot be fewer than 10; v. The company must submit its project to the minister of agriculture for approval; and vi. The company must make investments amounting to at least 25,000 UVT, approximately COP857m ($293,000), within a maximum term of six tax years.

Mega-Investments

The law also created a benefit for taxpayers that make sizable investments, i.e., investments of 30m UVT or more, equivalent to approximately COP1.03bn ($352,300). These taxpayers would be entitled to a corporate tax rate of 27% for a period of 20 years.

The investments should be made in productive machinery, plants and buildings within a maximum period of five years. The acquired assets may be depreciated over a two-year term. The taxpayer that decides to make a mega-investment may choose to enter into a tax stability agreement with the government.

VAT

As noted, the initial proposal of the government, which consisted of extending the tax to all goods and services, did not prosper. A few modifications to the regime were, however, included in the reform. Some of these modifications are detailed below.

Tax on Carbonated Beverages & Beer 

Tax on carbonated beverages and beer used to be accrued only on first sale or import; as of the reform, it must be charged at every distribution stage, via debit and credit mechanisms, as with any other VAT-liable product.

VAT on Franchised Restaurants

Until 2019 franchised restaurants had to collect excise tax and not VAT on their sales. This meant that any VAT that they paid was not creditable, becoming an additional cost for the business. This placed a very heavy burden on franchised restaurants, given the impact of the VAT that they had to pay on the payments to the franchisor.

Law No. 1949 allows franchised restaurants to choose either to continue collecting excise tax or to start collecting VAT. Franchised restaurants that opt to collect VAT must inform the Tax Office before June 30, 2019.

OBG would like to thank EY Colombia for its contribution to THE REPORT Colombia 2019