Dogs and Taxes in Latin America

According to Jorge G. Castañeda, a former Foreign Minister of Mexico, and Stephen Haber, a professor of political science at Stanford University in the US, Latin America (despite pockets of resistance) is entering a phase of unprecedented political and economic stability, which is amply illustrated by the degree of progress being made in countries such as Brazil, Chile, Costa Rica, El Salvador, Mexico, Panama, Peru and Uruguay.

In varying but nonetheless positive degrees these countries have pursued good macroeconomic policies that have effectively fought inflation; they have opened their markets and encouraged investments. The result is a significant shift towards more economic opportunity, social mobility and political democracy.

Meanwhile, developed countries are frantically trying to plug holes in a desperate attempt, following the Great Recession, to recover the maximum amount of tax from individuals and others to compensate, in part, for their own mismanagement of their economies.

Although Latin American governments, in the main, have relatively healthy economies, the collection of taxes is a major problem - in many cases taxes are high for individuals and corporations, the regimes are complex for taxpayers to comply with and there are insufficient tax collectors with the necessary expertise to enforce them. Latin Business Chronicle’s Latin Tax Index reports that Brazil has the worst tax environment in Latin America while Chile has the best. (The index measures a country’s overall tax climate by considering these factors: corporate tax rates, tax rates as a percentage of profits, and the number of payments and hours spent to pay taxes yearly.)

Those Latins lax with their taxes feel no real pressure because of the creaking tax systems most of which still need a complete overhaul. This, however, is changing as governments start shifting more towards direct rather than indirect taxes. As economic progress is made, more sophisticated tax regimes are being created, which will encourage sensible tax planning. It will include international structuring to mitigate taxes for sophisticated businessmen.

Tax rates, excise taxes and contributions have increased and whilst a few countries in the Americas have territorial tax regimes, the majority now have a worldwide taxation policy. The quality of the tax departments across Latin America today is like the curate’s egg: good in parts. Argentina, Brazil, Bolivia, Chile, Colombia, Guatemala and Panama stand out as having officials with a reasonable level of tax competency and technical knowledge. Collecting the taxes is another matter.

Let me mention some of the problems the tax systems face. The level of tax evasion in Latin America is high. Evasion is part of the business culture; sadly, in addition to this many citizens simply don’t trust their governments to use the taxes for the common good. It must, however, be understood that evasion can be part of a survival strategy for those firms that would fail because of onerous and cumbersome regulations. And do remember that evasion, like corruption, is an international issue. It is estimated that €100 billion a year is lost in taxes in Italy, about six per cent of GDP. Complexity compounds the problem and it seems to be a vicious circle that can only be broken if governments start to simplify the tax regulations. Until this is addressed, tax revenues in Latin America will remain low by international standards. And while firms in high-income countries spend an average of 177 hours a year in tax-related transactions (such as preparing, filing and paying taxes) Latin American businessmen on average spend 320 hours doing the same thing. In Bolivia that figure is 1,080 hours and in Brazil, the region’s economic powerhouse, an incredible 2,600 hours.

In Latin America the largest percentage of tax revenue comes from corporations so corporate tax income is crucial to the region’s tax collection system. That said, the majority of the firms are small enterprises and perhaps over 80 per cent of manufacturing establishments employ fewer than 10 workers (often referred to as micro-enterprises). In the services sector this percentage is even higher and in Mexico, for example, 97 per cent of retail establishments fall into the category. Collecting taxes is a nightmare, even before addressing evasion, and I am reminded of Dr Johnson’s dog that walks on its hind legs rather badly, but even so one is surprised that it can do it at all. And introducing special tax regimes for such micro-enterprises has not really eased the problem. In one study of 17 countries, 13 of them have at least one special tax regime for smaller companies. But if the regime is simple, applying to qualify for it, by going through bureaucratic hoops, is not.

There are so many small firms in Latin America that it is very difficult for the tax authorities to track them down; because of this, efforts are concentrated on the easy prey. This means that the main targets are the largest and most productive firms in Latin America. But if large firms are targets they are also sometimes guilty of tax evasion too. What is for sure is that tax authorities need to spread the burden more evenly and ratchet up the efforts to increase the amount of taxes paid by individuals.

Even so, low levels of personal income limit the scope for income taxes in Latin America and the region continues to lead the world in income inequality according to the OECD. This inversion of the personal tax pyramid, with the pinnacle supporting the system (including social security contributions) and too few contributing to it remains a key issue, whereas in Japan and much of Europe, unlike Latin America, this is unavoidable due to ageing populations.

It seems, therefore, that most revenues in Latin America are derived from imports and state-owned enterprises. In some countries the large, small and micro-enterprises under-report as much as 40 per cent of sales. Take Mexico, for example, where McKinsey and Company claim nearly 70 per cent of micro-enterprises are not registered and so pay no taxes. Sixty-three per cent of registered small and medium size firms report not paying taxes at all and 48 per cent of large firms don’t pay any taxes either. Just a couple of years ago the Mexican government received 40 per cent of its revenues from petroleum.

A study by the Inter-American Development Bank on the various tax regimes says: “At the end, these regimes create incentives for firms not to grow beyond a certain point. If they invest and grow, they will not be entitled for such special treatment and their taxes will increase dramatically. The additional taxes they will have to pay will, many times, not pay for the investments they make. So they simply don’t invest”.

As I say, governments need to streamline and simplify their systems. It is estimated that only one in three Latin Americans is subject to income taxation and more than half of all Latin American workers are not entitled to pension rights through their jobs.

Brazil is leading the way on the matter of tax collection from rich individuals with assets offshore. Legislation published in June named 65 jurisdictions that the government considered as tax havens in addition to those classified as having tax privileges that work against the spirit of Brazilian tax laws so will be subject to special tax requirements. Those named include four Latin American countries: Costa Rica (the only one that is not a finance centre of some description), Belize, Panama and Uruguay. In the classic sense Panama is not a tax haven with, at the time of writing, seven per cent VAT, corporate tax rates of 27.5 per cent and individuals subject to 25 per cent.

One casualty of Brazil’s tax changes is the US Limited Liability Company through which many foreign individuals and multinationals invest. A new blacklist has been created, split between low tax jurisdictions and tax privileged regimes. When the LLC is composed of non-residents not subject to federal income taxation it will be classified as a tax privileged regime. At this stage it is not clear whether just one non-resident member would trigger the classification. For now this and several other practical issues have still to be ironed out, and bear in mind that the classifications are subject to changes in the future. It is also known that the Brazilian authorities have been very critical of the US state of Delaware, especially concerning corporate secrecy.

Being a blacklisted LLC means:

1. Transfer pricing and thin capitalisation rules.
2. Capital gains of at least 15 per cent.
3. Withholding taxes of at least 15 per cent.

For non-resident investment funds which have enjoyed exemption from capital gains on the disposition of shares in publicly-traded Brazilian companies using a US LLC, this will be a harsh blow, and for most large and medium-sized multinational companies investing in Brazil through US LLCs, preferential tax withholding rates on interest and royalties is important. These changes therefore might see a flight of LLC business in favour of, for example, a US or Canadian limited partnership or a UK LLP, but like the rhythm of the beat in Rio de Janeiro’s Carnival, things can change suddenly with Brazil’s tax system.

Whatever the tussles over taxes might be, it is important that as Latin America moves out from the economic darkness of the past it must avoid stumbling in the sunlight. Failure will just feed that existing body of prejudice, which is now, I suspect, also tinged with envy. That said, no amount of evidence will convince some, however, because of the ‘Worm Syndrome’. Let me explain. In an effort to warn a meeting of Alcoholics Anonymous about the dangers of drink a religious minister dropped a worm into a jar of pure alcohol. It disintegrated almost upon impact and the minister, with furrowed brow and stern gaze, asked: “What does that tell you about alcohol?” A voice from the back of the room replied: “that you’ll never get worms”.

Worms or otherwise, if, as predicted, Panama does achieve the highest regional growth in GDP in 2015, it, like several other rising stars in Latin America, must be careful not to become intoxicated by success and be incautious.

Derek Sambrook
Derek Sambrook is a member of the Society of Trust and Estate Practitioners in the United Kingdom and obtained the Trustee Diploma of the Institute of Bankers in South Africa in 1973, becoming a Fellow of the institute in 1996. He emigrated in 1977 from Rhodesia (now Zimbabwe) where he was branch manager of a trust company and continued his profession in North America (Miami), Europe (including London and the Channel Islands), and the Caribbean (including the Cayman Islands). He has lived in Panama since 1996 where he is the Managing Director of Topaz Services, S.A. (www.trustservices.net), a Panamanian financial services company. He was Treasurer of the British Chamber of Commerce Panama for several years. Mr Sambrook‘s regulatory experience began in the corporate division of the Rhodesian (now Zimbabwe) Ministry of Justice (1965-1970) and subsequently he was appointed by the British government (1989-1992) as the first Bank, Trust Company and Insurance Regulator in the Turks & Caicos Islands, British West Indies; he established a regulatory body and drafted trust and insurance laws, banking and other regulations including licensing guidelines. As a direct result of his innovative captive insurance law, the Turks & Caicos Islands at the end of his contract had more than 5,000 producer-owned reinsurance companies and was the leading domicile in the world for this service. During his tenure he was also an affiliated member of the Latin American and Caribbean Banking Commission and Chairman of the government’s Offshore Financial Services Committee. He was a columnist for a leading United Kingdom offshore financial journal for over 15 years. His newsletter, Offshore Pilot Quarterly, has been published since 1997. In 2021 he celebrated 50 years in the trustee profession.