The recent global economic crisis led to a decrease in international trade and output, along with a corresponding drop in foreign direct investment throughout the world, including Latin America. According to the World Bank, foreign direct investment in Latin America fell to approximately $77bn, down 42 percent from record highs in 2008. South America declined by about 40 percent to $54bn, and Mexico and the Caribbean saw declines of about 46 percent to $22bn. Despite these drops, foreign direct investment for the region in 2009 was still the fifth-largest amount ever, and Latin America's growth outlook is expected to exceed that of Europe and the U.S. through 2012. Although there is still some uncertainty, the long-term trend remains upward - there are already signs of a recovery with announcements of new investments as well as deal activity. Estimates suggest Latin America is on track for a recovery second in strength only to Asia's, with sufficient levels of growth to bring foreign direct investment back above $100bn in 2011, an increase between 40 percent to 50 percent. Brazil in particular is expecting significant growth in foreign investment and infrastructure development as it prepares for the 2014 World Cup and the 2016 Summer Olympic Games.
As activity in the region grows and customers become more complex, companies are increasingly seeking opportunities in their business model to remain competitive. This attempt may increase transactions and layers in the supply chain, ultimately leading to greater complexity and potentially unwanted tax risks or costs. As companies conduct business in different jurisdictions with varying legal frameworks, currencies and consumers, the complexity of conducting business increases. Furthermore, countries in the region are also competing with each other and those in Asia to attract foreign investment. As a result, Latin American countries have seen more opportunities to join the global supply chain of multinational companies in a manner consistent with their Asian or European counterparts. Previously, multinational companies that implemented supply chain models to gain efficiencies in procurement, logistics, tax and treasury were limited to the European or Asian regions. In numerous cases, the Latin American region has been excluded from participating in the supply chain structure due to tax complexities or smaller revenue levels. Considering Latin America's growth potential, this trend should shift, resulting in a greater focus on supply chain structures in the region.
On the other hand, the tax authorities in Latin America are becoming increasingly sophisticated, presenting both challenges and opportunities. For example, an increased number of treaties are being signed or negotiated. Countries like Panama are, for the first time, negotiating, signing and ratifying OECD-based tax treaties. Chile also is expanding its treaty network, including a recently signed treaty with the United States that is awaiting ratification. Furthermore, most countries in the region have adopted formal transfer pricing rules and regulations and, with the notable exception of Brazil, accept traditional OECD methods. This can be an advantage when allocating income to these countries based on risks and functions, but it also represents increased compliance and potential examination on cross-border transactions.
Countries are also introducing certain tax changes in an effort to increase tax collections and to prevent abuse of the manufacturing programs intended for exports. For example, Panama has introduced a 5-percent withholding tax on dividends paid from foreign source income, including companies operating in the Colon Free Zone, that were previously exempt. In addition, Mexico recently made changes to its Decreto para el Fomento de la Industria Manufacturera, Maquiladora y de Servicios de ExportaciÃƒÂ³n, or IMMEX program (former Maquiladora regime), by introducing anti-abuse measures that may affect certain companies operating under this regime.
Although many companies still use non-Latin American "hubs" for the region, such as Switzerland and the Netherlands, multinationals are increasingly looking at establishing local regional hubs due to higher demand and in an effort to optimize logistics. Other multinationals have organically established hubs in their largest markets such as Brazil, Mexico or Argentina, which can result in increased tax costs.
The usual suspects for regional hubs have been territorial jurisdictions such as Panama or Uruguay. The latter taxes only 3 percent of the net income earned from foreign operations - its "trading regime" - leading to an effective rate of less than 0.75 percent. Panama is perceived as a regional hub due to its strategic location, favorable tax jurisdiction (free trade zones, territorial tax system) and capable infrastructure.
Until recently Panama had not concluded any tax treaties. In the past year, however, Panama has been negotiating treaties with several jurisdictions, and it recently signed treaties with the Netherlands, Portugal, Mexico and Barbados. Starting in 2010, Panama introduced some changes to the Colon Free Zone companies, such as levying a 5-percent withholding tax on dividends that had previously been exempt. The tax exemption on most foreign source income still remains in effect, to the extent that certain conditions are met. In addition, a commercial license tax (up to $50,000 a year) is also applicable for companies operating in the Colon Free Zone.
Panama also has a headquarters company regime for regional HQ operations. Under the regime, a company with a Panamanian headquarters is exempt from income tax for those services rendered to residents abroad that do not generate taxable income in Panama, provided such services are rendered only to non-residents. In addition to the common corporate exemptions, there are additional tax benefits that may be obtained for expatriate individuals meeting certain requirements and operating under a particular type of visa.
One note of caution: although territorial jurisdictions offer some significant benefits, they are often perceived as tax havens by other countries in the region, such as Mexico, Brazil and Ecuador, with many countries penalizing certain transactions with low-tax jurisdictions.
FTZs and Manufacturing Programs
Most countries in the region generally have some form of free trade zone (FTZ) or manufacturing programs for exports - regimes primarily intended for export manufacturing or development of a particular industry or geographical area. However, these programs have varying qualifications. For example, to qualify for Brazil's Drawback Regime, a manufacturer must meet certain minimum value-added requirements and carry out only specific activities. Under this program it is possible to import raw materials through a buy-sell operation or a consignment agreement (tolling operation). Today, local raw materials can also be acquired using this Drawback Regime in order to suspend the VAT (indirect taxes) on the local acquisition.
In the case of Mexico's maquiladora or IMMEX program, the qualifying requirements are related to a percentage of exports threshold. Although not strictly an FTZ program, the IMMEX program has maintained its competitiveness for manufacturing and remains a vehicle for companies manufacturing for both the local Mexican market and exports. The IMMEX program originated as the Maquiladora and Pitex programs, which allowed the temporary importation of goods (e.g., machinery and equipment, tools, raw materials) with no customs duty or import VAT cost. The customs benefit has since been replaced by programs such as the North American Free Trade Agreement, but the IMMEX regime continues to offer numerous tax benefits. A permanent establishment (PE) exemption for the foreign principal, Presidential Decree tax credits and preferential VAT and transfer pricing rules have resulted in the continued - and even increased - use of the IMMEX regime for companies manufacturing in Mexico that meet certain threshold levels of exports (at least 10 percent of total production or $500,000 in exports).
The IMMEX program recently was modified via a decree published in Mexico's Official Gazette on December 24, 2010. As part of the modifications, the decree redefined what qualifies as maquiladora activities for purposes of a number of existing taxes, such as income tax, flat tax and other transfer pricing incentives. The most significant change declared that at least 30 percent of the machinery and equipment used in the maquiladora operations should be owned by the foreign resident principal (previously there was no threshold). The changes presumably are aimed at limiting existing Mexican companies from converting to toll manufacturers operating under IMMEX in order to avail themselves of the regime's tax benefits. Qualified companies already operating under the program prior to December 31, 2009, are grandfathered under the pre-existing rules. Despite the changes, there are still opportunities for managing the supply chain in Mexico in a tax-efficient manner, with or without the IMMEX program.
Unlike Mexico, most other FTZ programs in Latin America generally are limited to certain geographical locations. For example, companies operating under the Tierra del Fuego regime in Argentina can obtain 100-percent corporate income tax and minimum presumed income exemptions, as well as VAT exemptions. In addition, the regime offers incentives on import/export duties and individual taxes for employees working in Tierra del Fuego. In addition to the Colon Free Zone, Panama has established the Panama Pacifico (Howard) Special Economic Area. While the Colon Free Zone includes companies that operate as distributors and logistics companies (e.g., re-packing, labeling), Howard's incentives are intended to attract back-office operations, call centers and other industries such as transportation and high-tech, among others.
Colombia offers two different regimes. The Plan Vallejo system allows Colombian residents to import raw materials into Colombian territory (even though not imported into a specific FTZ) with the suspension of customs duties and VAT, if final products are exported, and provided certain minimum investment requirements are satisfied. Under Colombia's general FTZ regime, goods shipped into a FTZ from outside of Colombia are not considered imports, so these introductions of capital goods, spare parts and raw materials are not subject to custom duties or VAT. If final products are sold to the Colombian territory, the operation will be considered an import and taxed for customs purposes only on the foreign content. Goods shipped into the FTZ to be exported to third countries will not be subject to custom duties and VAT as long as these goods are transformed within the FTZ. However, unlike other FTZ regimes currently in force in Latin America, the Colombian FTZ regime does not limit the application of the regime to transactions carried out with foreign entities, and it does not provide for an outright income tax exemption for entities located in the FTZ. However, it does provide a reduced income tax rate of 15 percent (as opposed to the 33-percent general rate). Under the right circumstances and if it meets the minimum investment thresholds, a company may be able to transfer certain activities to an FTZ company to be taxed at the lower 15 percent rate.
Brazil's Manaus Free Trade Zone offers special tax incentives to attract businesses to the underdeveloped Amazon region. Foreign goods used in the Manaus Free Trade Zone for consumption, manufacturing or assembly, and goods imported for storage that will be re-exported, are exempt from import duty, PIS, COFINS and federal VAT (IPI). The government of the State of Amazonas may also grant an exemption and/or a reduction on the state VAT (ICMS). Furthermore, the corporate income tax rate is reduced by 75 percent, and goods leaving the zone for the local market will receive a 100-percent federal VAT reduction. In order to qualify for these benefits, the company must obtain prior approval from the relevant Brazilian authorities. Approval generally is granted for projects that involve a minimum manufacturing process and meet other requirements described in the Brazilian tax legislation.
Areas for consideration
Permanent establishment. Many countries in the region have a very broad definition of what constitutes a PE, leading to the often unwanted risk of creating a taxable presence. Because many Latin American countries lack a formal PE definition, tax treaties are increasingly important to global supply chain structures. Treaty definitions provide clarity to treaty partners as well as a framework for domestic interpretation.
Argentina has a narrow definition of what constitutes a permanent establishment, whereby consignment manufacturing could create a taxable presence, even if done exclusively for exports. Notably, contract manufacturing for exports generally would not give rise to a PE.
Colombian tax law does not define a permanent establishment as a premise to tax business income in Colombia. Any activity rendered within the Colombian territory is immediately sourced by the Colombian provisions; however, under the code of commerce, a PE requires the setup of a taxable presence. Colombia's tax treaties with Spain and Chile provide a narrower definition of a PE consistent with OECD Model treaty.
Mexico has a broad definition of a permanent establishment in its domestic law, but its treaty network follows the OECD Model. However, not every situation is clear under a treaty. For example, the Mexican tax authorities often take a stricter interpretation of a PE when there is more than one auxiliary activity, even under the definition of a PE within its treaties. Using the IMMEX program may qualify a toll manufacturer's principal for a PE exemption pursuant to a special provision under Mexico's domestic law definition of a PE.
Brazil lacks a formal tax definition of permanent establishment, and there are few significant precedents and/or little guidance from the Brazilian tax authorities and tax courts regarding "taxable presence." In general, under Brazil's tax legislation there are specific situations that may give rise to a taxable presence for a non-resident entity. These include the presence of an agent that has the authority, and habitually exercises it, to bind the entity to a contract, a common trigger for a taxable presence in many other Latin American countries.
Value-added tax. VAT is a critical component of any supply chain structure, as it may represent a large and unrecoverable cost under certain circumstances. In typical supply chain structures in the Latin American region, VAT would apply on importation of goods into the country, on manufacturing charges and on the purchase and sale of goods.
While most countries in the region have a credit mechanism for VAT, recovery via refund mechanism is often not possible or may take longer than is normally anticipated. Generally, non-residents cannot register as VAT taxpayers in local countries in order to recover VAT without having a taxable presence or a fixed place of business in that country for income tax purposes.
In Mexico, for example, the recovery of VAT is available via a refund mechanism if output VAT exceeds input VAT. This is relevant in industries that have raw material importations but whose sale of the finished goods is zero rated, such as pharmaceutical companies.
Brazil has both federal VAT (IPI), federal social contribution PIS and COFINS, and a state VAT (ICMS). The IPI rate depends on the good's tariff classification, and the ICMS rate will depend on the state where the importation takes place. In the State of SÃƒÂ£o Paulo, the ICMS is triggered at a rate of 18 percent. ICMS is creditable only against input ICMS and cannot be recovered via refund or against other taxes. Under the right circumstances, the IPI, PIS and COFINS can being credited against other federal taxes.
In Argentina, only specific types of VAT credits can be recovered or credited against other taxes, such those arising from exports and local VAT withholdings, among others.
Because it is difficult for non-residents to register for VAT and sometimes challenging for local companies to recover VAT, supply chain structures must be carefully analyzed in order to avoid a potentially unrecoverable cost to the structure.
VAT generally would not apply on goods that are exported or imported temporarily under a qualified regime. For example, under certain qualified regimes, goods imported temporarily for transformation and processing and the related manufacturing fee are generally exempt from VAT. Furthermore, the DAC Bonded Warehouse is a special customs regime in Brazil that allows a foreign company to maintain products stored under customs surveillance, with the suspension of payment of the import duties and other taxes levied upon the importation of goods. The suspended taxes and duties only become due at the time of the effective customs clearance.
Certain programs like the IMMEX program in Mexico or the DAC Bonded Warehouse regime in Brazil may allow for a virtual exportation of goods, whereby the foreign resident is deemed to export the goods in a toll manufacturing arrangement. As such, the foreign resident may not have a VAT recoverability issue. However, other countries may require alternative structuring to reduce a potentially unrecoverable VAT cost. For goods imported temporarily that are later determined to remain in the country, VAT would normally be due when goods are "nationalized" - their status changed from temporary to permanent importation.
Business transformations and exit charges. In business transformations, a reduction in the functions and risks performed locally may decrease the taxable income of a local manufacturer or distributor. There are no special rules in Latin America countries that provide for imposing an "exit charge" or tax on the transfer of a going concern in a business transformation. However, most countries in the region have transfer pricing rules, and the potential need for compensation upon conversion could be challenged on the grounds that the transaction does not otherwise follow arm's length guidelines.
Furthermore, it may be possible in certain countries to obtain a ruling that provides more certainty on the tax implications of a change in the business. For example, in Venezuela it may be possible to request a customs ruling whereby the tax authorities may confirm the transfer price under a new model for customs purposes, which may also provide some comfort from an income tax perspective. Similar rulings could be obtained in other countries.
Customs and regulatory issues. Customs is an important issue in any type of supply chain structure. While regulatory issues such as needing a local importer of record are important, efficient customs planning to ensure the use of free trade agreements is critical to success and should not be overlooked. Penalties in the region tend to be very high and can lead to significant customs liabilities in the event of an underpayment or an assessment. Such assessments usually relate to improper origin claims, classification discrepancies, incorrect customs valuation and non-compliance with local regulatory requirements such as import licenses.
Companies reviewing their supply chain models should consider what customs benefits are available to properly choose their manufacturing and distribution hubs. In this regard, selected countries may provide customs benefits from both an inbound and outbound perspective via special import programs that defer or waive duties on imported components (e.g., IMMEX, Brazilian Drawback Regime). Companies may also benefit from preferential duty rates in destination countries through origin qualification of manufactured finished goods under diverse free trade agreements.
Latin America can be a manufacturing location for local sales or exports, the end market for manufactured products abroad, a source of natural resources and a site for infrastructure projects, leading to a range of supply chain processes. With increased regionalization, the number of cross-border transactions inevitably will rise and complicate reporting, including tax reporting. Supply chain strategies provide the opportunity to streamline the process, while at the same time optimizing the structure from a tax and treasury perspective.
Some companies are exploring opportunities to transform their supply chain in the region to be aligned with a global supply chain model, such as limited risk manufacturers and distributors, in conjunction with a global or regional hub. Planning opportunities may be explored in order to achieve a tax-effective business transformation. However, careful planning is critical when undergoing a transformation in order to ensure compliance with the applicable local tax rules. It is possible, even in absence of a manufacturing or free trade program, to manufacture in the region for exports without creating a taxable presence or other unwanted tax costs. Often, multinationals operating in the region are faced with complex transfer pricing rules or high withholding tax rates on royalty payments and management and headquarter fees. Consequently, moving to limited risk models may streamline the transaction and present tax savings.
While there is no one-size-fits-all structure for designing operations in Latin America, there are opportunities in virtually every aspect of a supply chain model - from procurement, warehousing and packaging to full-fledged manufacturing and distribution. Even though the region's countries are becoming more aggressive in targeting certain structures, the changing business model allows companies to reassess their structure and, in many cases, improve their tax position by being aligned to the business change.
The views expressed in this article are those of the authors and do not reflect the views of Ernst & Young LLP or any other member of Ernst & Young Global Limited.
Authors' bios: Michael Becka, Partner, Ernst & Young LLP, International Tax Services, Dallas; Terri Grosselin, Executive Director, Ernst & Young LLP, Latin American Business Center, Miami; Ana Gross, Senior Manager, Ernst & Young LLP, Latin American Business Center, New York.
Special contributors: Frank de Meijer, Ernst & Young Terco, Brazil; Pablo Wejcman, Ernst & Young LLP, Argentine Desk; Guillermo Lopez, Ernst & Young Panama S.A.; Ximena Zuluaga, Ernst & Young Ltda., Colombia; Armando Beteta, Ernst & Young, LLP, Customs & Trade, Dallas; and Martha Roca, Ernst & Young Uruguay Sociedad Civil.
Ernst & Young
Timely, incisive articles delivered directly to your inbox.