VAT the unknow and unwelcomed guest for US companies doing business in LatAm. By Leopoldo J Martinez and Carlos Contasti*

Imagine this dialogue between the CFO and the LatAm Tax Director: ¿Did you have someone look into the income tax withholdings or Permanent Establishment issues with our LatAm advisors? … Yes but they also suggested we consider some planning for VAT! … VAT? … Yes, an unexpected visitor.
VAT is an indirect and non-accumulative tax that levies consumption of goods and services. It is imposed on the amount of value added at each stage of the production process or the supply chain, thus, an exporter of goods, a service provider or a technology company providing a license or collecting a royalty must work around VAT.
VAT is one of the most important revenue sources for LatAm governments. Therefore its compliance is strictly enforced.  Accordingly, adequate VAT planning at the pre-business stage makes a difference.
Latin America countries differ from the European Union because there are no harmonized VAT rules and procedures. Each country has its own VAT system without any integration or collaboration between them. Moreover, some countries have a very complex indirect tax system, within the country. In Brazil, which is the largest economy in the region, the equivalent to VAT tax is disaggregated and distributed among its three territorial levels.  Industrial products sales are taxed at the federal level (IPI); all other goods are the subject of state taxation (ICMS); and services are a matter of municipal taxation (ISS). In addition, there are significant differences in tax rates for ICMS and ISS among the cities and states. As a result, there is a regional and local war to tax transactions when the fiscal base is established in low rate state or city, but the customer is located in another place.
The lack of regional harmonization represents an important challenge for services exported into LatAm. For instance, most of the LatAm countries would tax all services rendered within their territories regardless of the place of use or enjoyment, or the customer’s location.  In countries, like Venezuela, all services rendered within its territory, and services rendered from abroad (imported services), when used or enjoyed in Venezuela, are subject to VAT. Argentinean Law takes the approach of establishing that services rendered and used or enjoyed abroad are exempted from VAT. The use and enjoyment of the service approach is certainly an undetermined concept, and there are many different interpretations.
Normally, an exporter without an establishment or local presence deals with reverse VAT issues. Meaning that instead of collecting the tax from his client, the same is withheld by the client, who actually pays the tax. But other issues are relevant. In some jurisdictions it must be determined whether the transactions are a service or a royalty for intellectual property, in order to determine VAT exposure. Accordingly, contractually a license can be separated from related support services to optimize VAT exposure.
One key issue is VAT registration. In most LatAm jurisdictions it is prohibited that overseas companies register for VAT, unless they have some presence in the country, such as permanent establishment. However, in most of the countries in LatAm when a foreign entity permanently or habitually supplies goods or renders services it will be mandatory to register for VAT purposes.
There are some benefits associated with VAT registration. The potential benefits are: (i) the right to recover tax credits arising from export activities, (ii) the ability to manage VAT withholdings, and (iii) utilization of tax exemptions. Registration becomes particularly relevant when the company exporting services or goods into a VAT jurisdiction, for its commercialization or for support, is contracting with local providers charging VAT for their services, since VAT is estimated offsetting debits (VAT collected) with credits (VAT paid).  Particularly relevant in LatAm –and here is a fundamental difference with the EU system– a non-domiciled company, one not registered for VAT purposes, can not file a refund of tax credit. Using this rationale, big companies tend to do business with registered companies with the objective of recovering the VAT output generated in the transactions. Also, most of the VAT regimes exempt businesses with sales below a threshold established by the law Accordingly, VAT registration could be the basis of a VAT optimization strategy. When such decision is made, then a holistic approach to dealing with VAT and Income Taxation becomes necessary.
There are some countries in LatAm that have established certain VAT withholding methods, such as Argentina, Brazil, Colombia, Mexico and Venezuela.  Withholding obligations could take place when the taxpayer sells goods or renders services to the Federal, State or Municipal government or decentralized agencies, or because the transactions are made with a “special taxpayer”, normally a taxpayer with high revenues. VAT withholdings are not only a compliance problem; they represent a cash flow problem, because the final tax liability could result in a lower amount if there are VAT credits to offset the VAT debits.
VAT credits recovery is a practice in itself, whether from export activities, from inappropriate reverse VAT charges or from excess VAT paid as a result of a withholding imposed.
Finally, VAT compliance is an important issue to take into account. First, it represents an important cost. Second, non-compliance could trigger high penalties and business closures. Once more the lack of harmonization brings a complicated and entangled system. Commonly, compliance requirements such as bookkeeping, invoicing, record retention and return fillings are all treated in different ways, with some countries not accepting electronic invoicing (or requiring special approval for such practice). Electronic return filling has become popular in LatAm, but bookkeeping is especially entwined. In most of the countries there are books required by mercantile laws and specific books for VAT purposes.
VAT can certainly be an unexpected guest for U.S. companies doing business in Latin America. And without proper planning it can become a very unwelcomed guest.
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Leopoldo J Martinez (lmartinez@lmnconsultingllc.net) is the Principal of LMN Consulting LLC, a consulting firm specialized in tax, regulatory and compliance in Latin America, with operations in Washington DC, Dallas, Miami, Caracas, Mexico and Panama. Carlos Contasti (ccontasti@lmnconsultingllc.net) is an Associate of LMN Consulting, with his practice based in Caracas-Venezuela.

Achieving Tax Efficiency with cross-border services and royalties in Latin America. By Leopoldo J Martinez*

In the global economy the growth of royalties and services associated to intellectual property and information technology has become critical for international taxation.  On one-side governments of importing countries regularly source payments as territorial, based on the jurisdiction or location of payor. On the other, exporting countries push to resolve the issue through tax treaties. Unfortunately for US companies, one of their natural expansion markets is a “no-tax-treaty battleground”: Latin America (only Mexico and Venezuela have treaties with the US. A treaty with Chile is expected to be ratified by both countries soon).

Achieving Tax Efficiency with cross-border services and royalties in Latin America presents an important tax planning challenge in outbound taxation for US companies; as the corresponding inbound activity in Latin American countries is subject to high rates of income tax withholdings, and eventually, reverse VAT issues. In countries like Brazil, on top the income withholding tax issues, the scenario becomes even more complicated when the CIDE tax becomes applicable. The CIDE tax is a 10% surcharge withheld on certain services or royalties considered to be importation of technology. As such, the CIDE tax will not be creditable against US income taxes under the Internal Revenue Code, as it is not an income tax nor in lieu of income taxes.
The subject has become increasingly important, particularly in absence of tax treaties. In the US, under the Internal Revenue Code, the tax credit system might be insufficient to resolve the issue from a cash flow perspective; and, secondly, it might present some tax optimization issues as well. Thirdly, another problem could arise when the royalty or service activity is parallel to certain support services, programming or commercialization activities in the importing country. Generally the use of independent contractors could be problematic and eventually not escape potential tax liability issues, including those emerging from the notion of “engagement in a local trade or business”, in absence of a protective permanent establishment provision per a tax treaty.
Three options to consider, from a tax planning perspective are:
1.     Playing as a local with a Tax Hybrid. Reducing withholding taxation on the overseas service payments by creating a Sociedad de Responsabilidad Limitada (hereinafter referred as “SRL”), which is the equivalent of an LLC (or other eligible entity under the check-the-box regulations). This option is optimal when treaty networking becomes complex, expensive or unviable, as well when the growth is focused or concentrates in a particular country.
The SRL (or eligible entity) will become a tax hybrid, thus a disregarded entity in the US but a legal independent entity in the Latin American country. Accordingly the entity is a blocker and a conduit at the same time. As such, the parent company is protected from tax exposure or any other liability issues locally (particularly relevant when there is related marketing or support activity in the importing country), but from a tax perspective all taxes paid flow-through as direct tax credits, and all expenses as deductions, including as the latter all indirect taxes paid.
The key in this planning technique is that income tax withholdings on local payments for services or royalties are very low (or none), compared to the high rates applicable to cross border payments for the same. Additionally, the withholding tax is applicable over the gross amount paid, whereas the entity is taxed on a net basis. Most jurisdictions in Latin America do not tax dividends when declared after previously taxed profits or earnings, but this is an important issue to look country by country as a pre-condition, because it is necessary to ensure that surpluses flow back without tax implications. Thus, with proper planning, the efficiency and savings are significant.
In countries like Brazil, where strategizing becomes highly relevant not only from an income tax perspective but from a CIDE tax and indirect taxation perspective as well, there are additional options to bring efficiency. Brazilian tax law allows that any legal entity provided that its income is below the BzR$ 2.4 million threshold, to elect taxation under the simplified “presumed profits method”. One alternative to consider is to create one SRL for each contract or revenue stream from royalties or services, to meet the income threshold necessary to meet the presumed profits method election. Accordingly, in a service scenario, the presumed profits are considered to be 32% of gross revenue. With nominal tax rates in the 35%, the effective rate of taxation upon this election becomes 11,2 (compared to a 25% flat withholding rate applicable, including the 10% CIDE tax, when the payments are made directly to a foreign provider or licensor). Finally, any net profits accumulated at the local entity in Brazil can be repatriated as dividends at 0% income tax withholdings. Another advantage of the presumed profits method is that it will significantly simplify local compliance and reporting packages.
2.     Treaty Networking. Avoiding withholding taxation on Service Payments adopting a Tax Treaty Country. Another approach if significant expansion is expected in several Latin American countries is to create an IP holding incorporated or filed on a jurisdiction with a good tax treaty network.
The critical factor is to overcome the limitation of benefit provisions provided under the treaties, as well as giving substance to the IP toolbox or holding. Jurisdictions of choice for Latin America are Spain and the Netherlands.
3.     Transactional Structuring. Another alternative to avoid withholding taxation on royalties and technical assistance is by creating and selling a legal entity. This approach is relevant in a transactional planning scenario. An entity is formed in an offshore low tax and non-blacklisted jurisdiction (preferably with a tax treaty) and capitalized with a contribution in pre-paid royalties and services. Thereafter, the local client, affiliate or partner purchases the stock in the capitalized offshore entity.
A jurisdiction to consider in this planning technique is Barbados, as it is not blacklisted by the OECD and has tax treaties with a number of countries, including the United States.

* Leopoldo J Martinez is the Principal of LMN Consulting LLC. A consulting firm specialized in tax, regulatory and compliance in Latin America, with operations in Washington DC, Dallas, Miami, Caracas, Mexico and Panama.