Recent Chilean Tax Reform Reinforces Need for U.S. Tax Treaty
Chile is the fifth largest economy in South America and increasingly one of the most significant U.S. trading partners in the region. U.S. foreign direct investment into Chile was $39.9 billion for 2012 (the latest year for which official figures are available). And in 2013, the U.S. exported $17.6 billion of goods and services to Chile, making Chile the second largest destination for U.S. exports in South America and the 19th largest worldwide. Trade between the U.S. and Chile has been facilitated by the U.S.-Chile free trade agreement (the “FTA”), which came into force in 2004 and is one of only 20 such U.S. agreements worldwide, and one of only three such U.S. agreements in South America.
Unlike the U.S. corporate tax system, under which both corporations and their shareholders are independently taxed on the income of the corporation, Chile has an integrated tax system. Under this integrated system, Chile collects an aggregate 35 percent tax on business profits. This aggregate tax is imposed at two levels. First, business profits of Chilean resident companies are taxed at a rate of 20 percent. This in essence represents an advance payment of a portion of the aggregate 35 percent tax. Second, in the case of nonresident shareholders, actual distributions to such shareholders are taxed again, on a gross basis, at a rate of 35 percent. Such nonresident shareholders are, however, permitted to claim a credit for the 20 percent corporate tax paid against this 35 percent shareholder level tax. The effective shareholder level tax rate after accounting for the credit is thus 15 percent.
Pursuant to recent Chilean tax reform legislation, which went into effect on October 1, 2014, corporate tax rates in Chile gradually will increase until 2017, when they will peak at 25 percent (or in some cases, beginning in 2018, 27 percent under related provisions further discussed below). More significantly, beginning in 2017, Chile will adopt a new dual tax system in place of the existing integrated system. Under this new dual tax regime, shareholders can opt to be taxed under either of the following two systems: (1) the “Attributed Income” System; or (2) the “Semi-Integrated” System.
Pursuant to the Attributed Income System, all “attributed income” will be taxed to shareholders on an accrual basis at the time the income is earned by the corporation, regardless of whether such income is actually distributed to the shareholders. This method of taxing the shareholder is similar to the taxation of a U.S. shareholder on subpart F income pursuant to the controlled foreign corporation provisions under U.S. law. The effective tax rate under this Attributed Income System would be 35 percent, as under the current Chilean system. Thus, the corporation would be subject to a maximum corporate tax rate of 25 percent (beginning in 2017), with the nonresident shareholder being subjected to a “withholding tax” of 35 percent, but offset by a full credit for the tax already imposed at the corporate level. The only difference between this new system and the existing integrated tax regime is the loss of deferral at the shareholder level in situations where distributions are not made to shareholders on an annual basis. Stated differently, if the Chilean company in question is not accumulating any income, but rather is distributing all of its income on an annual basis, the new system is ultimately no different from the existing system (other than the slightly increased corporate level rates). If the company does accumulate income, however, the new system is less favorable to shareholders than the existing system, because the tax liability of these shareholders will be accelerated and they will be subject to tax despite not receiving an actual distribution of cash from the company.
Under the other alternative, the Semi-Integrated System, the shareholder can instead continue to defer recognition of income until receiving a distribution, but this deferral comes at a cost. Here, the corporate level tax will be increased to 27 percent (beginning in 2018). The shareholder will be entitled to credit only 65 percent of the 27 percent corporate tax (i.e., 17.55 percent) against the shareholder level tax of 35 percent. Thus, the aggregate effective tax rate under this alternative system climbs significantly to 44.45 percent beginning in 2018.
Effect of Income Tax Treaties
The existence of an income tax treaty with Chile can alter the effects of the new tax regimes, particularly with respect to the Semi-Integrated System. In the absence of a treaty, a shareholder who opts for the Semi-Integrated System will be burdened with an increased tax rate of 17.45 percent, plus the 27 percent tax paid by the underlying company, resulting in a combined effective tax rate of 44.45 percent. A shareholder who is resident in a country with which Chile has a tax treaty, on the other hand, will pay a significantly lower rate thanks to the treaty.
Each tax treaty that Chile has entered into contains a so-called “Chile clause,” under which the usual treaty-based reductions in dividend withholding tax rates do not apply to dividends paid by a Chilean entity. In other words, the domestic Chilean 35 percent withholding tax continues to apply (rather than a 5, 10, or 15 percent rate under the treaty’s dividends article). However, these treaties typically provide that the full withholding tax is permitted in Chile only if the shareholder also is permitted a full credit in Chile for the corporate tax already imposed. Such treaties generally provide that if under Chilean law such a full credit is ever not available to the shareholder, then the Chilean withholding tax is limited by the treaty’s dividend provision (i.e., to 5, 10, or 15 percent). This ensures that Chile still gets to collect its aggregate 35 percent tax under its integrated tax system since the corporate level tax is really just a prepayment of a portion of such tax. But it also ensures that the shareholder’s risk of double taxation is limited. This double tax is avoided through a credit mechanism, or where that mechanism fails, through a reduced withholding tax rate pursuant to the treaty.
For example, the U.S.-Chile income tax treaty (the “Treaty”), which is not yet effective, contains a dividends provision under which the withholding tax on dividends paid by a resident of one country to a resident of the other country is reduced to 5 or 15 percent, depending upon ownership thresholds. This provision, however, only works one way, by reducing U.S. withholding tax on dividend payments by U.S. corporations to Chilean resident shareholders. Where a Chilean company pays a dividend to a U.S. shareholder, the “Chile clause” of the Treaty provides that the Chilean withholding tax rate of 35 percent is not reduced by the Treaty.
The technical explanation to the Treaty clarifies the purpose of the Chile clause by stating:
The proposed protocol reflects the unique operation of Chile’s integrated tax system and the Technical Explanation states that this paragraph is intended to prevent the avoidance of the [shareholder level tax]. The proposed protocol provides that the provisions of this article of the proposed treaty do not limit the application of the [shareholder level tax] provided that under the domestic law of Chile the [corporate level tax] is fully creditable in computing the amount of [shareholder level tax] to be paid. Accordingly, the Technical Explanation states that the proposed treaty does not require Chile to reduce the rate of [the shareholder level tax] withheld on dividends paid by companies resident in Chile and beneficially owned by residents of the United States. The proposed protocol provides that if at any time under the domestic law of Chile, the [corporate level tax] ceases to be fully creditable in computing the amount of [the shareholder level tax] to be paid, the amount of [the shareholder level tax] imposed by Chile will be subject to the limitations in the proposed treaty.
An obvious but significant implication of the Treaty not yet being finalized is that U.S. companies investing directly in Chile cannot rely on the Treaty to claim a 100 percent credit under the new system, and thus are faced with a potential 44.45 percent future tax burden, or alternatively, the loss of deferral and potential taxation without a corresponding receipt of cash. Thus, such companies may want to consider investing in Chile indirectly through an intermediary holding company that is resident in a jurisdiction that has income tax treaty in effect with Chile. (While not a necessity, it may also be beneficial if such holding company has in effect a bilateral investment treaty (BIT) with Chile. Such BITs generally serve to protect private investment, develop market-oriented policies in partner countries, and promote trade between the countries in question. Query whether the existence of a BIT alone between Chile and the intermediary jurisdiction may be enough to override the new system and permit deferral and a full credit in the same way that a tax treaty would. Some commentators have suggested this may be the case in appropriate circumstances. ) If properly structured, this should permit such U.S. investors to both defer recognition of the income until the payment of an actual cash distribution is made to them and benefit from a full credit pursuant to the Treaty, so that the maximum effective tax rate remains 35 percent.
Ideally, such a jurisdiction would be one that exempts dividends (under a “participation exemption” or “exempt surplus” regime) from local corporate income tax and also permits the U.S. shareholders to claim treaty benefits with respect to outgoing dividends. Examples of potential jurisdictions meeting these requirements include, for example, Australia, Canada, Spain, Switzerland, and the U.K. (While the treaties between these jurisdictions and Chile currently do not contain “limitation on benefits” provisions similar to those in U.S. income tax treaties, query whether the treaty-based benefits sought through the use of such an intermediary holding company could be challenged on the basis that the holding company is not the “beneficial owner” of such dividends).
Other U.S. Tax Considerations
It is important to note that, if the intermediary holding company is a CFC (controlled foreign corporation) for U.S. purposes, further planning may be needed to avoid triggering subpart F income on the company’s receipt of the dividend from the Chilean company (unless an exception already applies, e.g., the high-tax exception). In addition, given the high effective tax rates in Chile, foreign tax credit issues also will need to be addressed to avoid taxation of the same income multiple times. Finally, if the U.S. shareholder is a pass-through entity, rather than a C corporation for U.S. purposes, individual owners of that entity may benefit from receiving “qualified” dividends in the United States when dividends are received from the intermediary treaty resident company. This tax benefit would not otherwise be available to such shareholders if they received dividends directly from a Chilean entity, given that the Treaty is not yet in effect.