Cross-border services and cost sharing

payments in Latin America: a minefield

!@ #
A special report prepared by Ernst & Young's Latin America Business Center

Latin American economies underwent sweeping changes in recent years and have attracted major foreign
investments. However, the Latin American tax systems that regulate cross-border services and cost-sharing
agreements (CSAs) have not kept pace. The tax landscape in Latin America is far from harmonized; indeed, it
can be characterized as a fiscal minefield. It is not always clear how complex domestic rules should be
applied; tax and exchange control rules may change rapidly or may be in conflict with international
arrangements. The domestic legislation of various Latin American countries does not provide (sufficient)
guidelines, on how to deal with international CSAs and local tax authorities are generally not familiar with
US or OECD transfer pricing guidelines or double tax treaty provisions. This creates confusion and
uncertainty among multinationals and constitutes an important barrier for the construction of tax-efficient
regional strategies.
Outbound service fee payments may qualify as business profits, as royalties or as interest under local tax
legislation or double tax treaties. The terms "technical services" and 'technical assistance' are defined or
understood in different ways in the various Latin American countries. The withholding tax rates applicable to
outbound services fees and royalties remain high in the region.
All the countries participating in this survey recognize the principle that expenses incurred to obtain, maintain
or preserve taxable income are deductible for local taxation purposes. However, it is not unusual for payments
resulting from CSAs to not be accepted as deductible expenses by local tax authorities. It can be argued at
length, as to whether limitations to the tax deductibility of CSAs are in conformity with the double tax treaties
of certain Latin American countries. Arm´s-length principles and non-discrimination rules are often
disregarded. Most countries in this survey maintain that their transfer pricing (TP) rules are in conformity
with OECD guidelines. Mexico, the only Latin American country that is a member of the OECD, has invested
major efforts to bring tax regulations and policies into conformity with OECD guidelines. Brazil is less
responsive to OECD principles and guidelines, and it is debatable whether the Brazilian transfer pricing
methods are compatible with OECD arm´s-length principles.
In addition to Mexico, Argentina, Brazil and Chile, as non OECD-member states, also adhered to the OECD
Guidelines for Multinationals in June 2000. Although observance of the Guidelines for Multinationals by
enterprises is voluntary and not legally enforceable, governments adhering to the Guidelines encourage the
enterprises operating in their territories to observe the Guidelines wherever they operate. From a tax
perspective, multinational enterprises are encouraged to follow the guidance in the OECD Transfer Pricing
Guidelines, as amended and supplemented, to ensure that their transfer prices reflect the arm's-length
principle.
Cost sharing can be defined as a relatively simple concept, enabling R&D expenditure to be funded on an
equitable basis by a group of companies. However, in Latin America, many complex issues need first to be
carefully addressed before establishing a tax-efficient cost-sharing agreement between companies in the
region.
The country-specific discussions in this article are divided into three topics:
1) Deductibility;
2) Withholding taxes; and
3) Tax treaty implications.
Deductibility
Argentina
Although Argentina has incorporated OECD principles into its transfer pricing legislation, there are no
income tax provisions that expressly deal with international CSAs. Accordingly, the deductibility of payments
made by Argentine residents in connection with CSAs must be determined by reference to the income tax
rules regarding deductibility of expenses.
In Argentina, expenses are tax deductible if they are related to earning, maintaining and preserving taxable
income. Accordingly, to determine the tax treatment applicable to the charges made to the Argentine
company, the nature of the services included and distributed through the CSA must be analyzed on a case-by-
case basis. The Argentine tax treatment applicable to the contributions may vary depending on the purpose of
the CSA.
The amount deductible as technical assistance received from abroad, if treated as royalties, is limited to 3% of
the sales or revenues considered as the contractual basis to determine the royalty payment for this service, or,
if treated as a fixed amount payment, to 5% of the amount effectively invested in the relevant project. On the
other hand, up to 80% of the amount paid to the foreign recipient may be deducted in the case of payments to
non-Argentine residents for the use of trademarks.

Brazil
As Brazilian regulations do not specifically address the issue of CSA-based payments, general income tax
rules regarding deductibility of expenses should be observed. As a general rule, the taxpayer must prove that
the incurred expenses are directly related to the company's activities; that is, the expenses are normal and
customary for the daily activities of the company. As a second requirement, the taxpayer must substantiate
that the expenses are actually incurred through providing documentation.
The Brazilian tax court has, however, pronounced that indirect expenses are deductible to the extent that the
allocation criterion is reasonable and the existence of expenses is proved. In a recent case, the Brazilian tax
court accepted net revenue as a reasonable criterion for the allocation of cost sharing expenses. Although this
precedent only covers the allocation of indirect costs in the local context (between Brazilian entities), it
provides guidance on the allocation of indirect costs in a cross-border context.
The deductibility of expenses related to agreements involving any kind of transfer of technology or royalty is
limited to 5% of the net revenue related to the agreement, depending on the activity carried out by the
company. The INPI is the competent body to determine whether the contract contains a transfer of
technology.
Finally, CSAs should follow the Brazilian transfer pricing rules whenever the transaction is between related
parties. Services involving the transfer of know-how do not need to comply with the transfer pricing
legislation.

Chile
Chilean law does not specifically address the issue of deductions in connection with costs incurred under a
CSA. Accordingly, the deductibility of such costs in Chile will be determined under general rules applying to
the deduction of expenses. In general, an expense is tax-deductible to the extent that: (i) it is mandatory and
necessary to generate income subject to corporate income tax; (ii) the respective expense is paid or accrued in
the respective tax period; and (iii) the amount of the expense is reasonable. In addition, the company (the
payee) must have the necessary documentation to prove the nature, the necessity and the amount of the
expense.
Even if a CSA is in place, the Chilean tax authorities may reject the proportionality used to allocate the
expenses and, accordingly, may not accept the amount of the deduction taken by a Chilean company.

Colombia
As Colombian regulations do not establish specific rules regarding payments deriving from CSAs, the tax
treatment applied to this type of agreement and payment will be determined by reference to the general rules
for payments, withholdings and deductions existing under Colombia's tax statute. The general rule on
deductibility provides that payments made by a taxpayer are deductible if: (i) they are necessary and have a
relationship with the income -producing activity; (ii) they are proportionate in size with income; (iii) they are
paid within the taxable period; and (iv) they are not restricted by law.
Mexico
Mexican regulations do not contain specific rules regarding payments under CSAs. Instead, general income
tax rules regarding deductibility of expenses apply. Under current local law, there is a provision that disallows
the tax deduction of any payment made on a pro rata basis; this makes it difficult (if not impossible) to take a
deduction under a CSA.

Peru
Peruvian regulations do not establish specific rules regarding the tax treatment of payments deriving from
CSAs. Accordingly, general income tax rules regarding deductibility of expenses must be followed.

Venezuela
Venezuela does not have any specific rules in its income tax law (ITL) related to CSAs. It is generally
accepted that CSAs are implemented to jointly develop intangibles, and according to the ITL, payments in the
nature of royalties, technical assistance and technological services are not subject to transfer pricing rules, but
to the general limitations established in the law.
For an expense to be deductible in Venezuela, it has to meet the following criteria: (i) being ordinary and
necessary in nature; (ii) incurred in Venezuela; (iii) as a means of obtaining local profits. In the case of
technical assistance from abroad, technological services, and royalties, the territoriality requirement is
waived. Thus, in the case of CSAs, and assuming requirements (i) and (iii) are satisfied, expenses for CSAs
may be deductible in Venezuela. To guarantee the deductibility of the foreign incurred expense, a legally
executed instrument, such as a technical assistance or technological services agreement, proves critical.
The ITL establishes two major limitations on the deductibility of services of a technical nature. If the
technical assistance service or technological service is contracted from abroad, but could have been procured
from local contractors, the payment for such services is not deductible. The other limitation disallows the
deductibility of payments in the nature of royalties, technical assistance, technological services and others,
made by a permanent establishment to its home office, or a related company, with the exception of
reimbursement of actual expenses.

Withholding taxes
Argentina
In general, payments for services rendered by non-residents are not subject to withholding tax unless
performed within Argentina. Nevertheless, technical assistance, even when provided from abroad, is deemed
to be Argentine source income and therefore payments for technical assistance are subject to withholding tax.
Therefore, payments for services rendered abroad by non-residents are not subject to withholding tax. An
exception exists for technical assistance or other types of services, such as broadcasting and insurance, for
which the law provides specific tax rules.
As CSAs often involve services that benefit several countries, and are not specifically designed for the
operations of a single country (ie Argentina), payments under CSAs in Argentina can often be characterized
as made as compensation for general services and not technical assistance services. Consequently, in
Argentina it could be possible to avoid the application of withholding taxes on payments made in connection
with CSAs.
In general, payments for technical assistance are subject to a 31.5% withholding tax-rate or 28% if there is a
registered agreement with the National Institute of Industrial Property (INPI) (though such rate may be
reduced to 21% if certain requirements are met). Payments for the use of trademarks are subject to
withholding tax at 28% so long as they are registered with the INPI.

Brazil
The reimbursement of expenses incurred abroad should be subject to withholding tax in Brazil since it will be
treated as income earned by a non-resident. In practice, the Brazilian tax authorities will characterize cost-
sharing payments as fees for services rendered abroad. Accordingly, they apply a 25% withholding tax rate on
such payments. This taxation is applied regardless of the country of residence of the recipient. It is
questionable whether the above position of the tax authorities is in accordance with Brazilian domestic
legislation and double tax treaties.
Chile
According to Chilean legislation, all service payments made by Chilean companies to non-residents in Chile
are subject to withholding tax even when services are rendered abroad. The general withholding rate is 35%.
Royalty and technical assistance payments are subject to a reduced withholding tax rate of 30% and 20%,
respectively. Administration service payments (including management fees) are subject to the general
withholding tax rate of 35%.
In a CSA, payments made from Chile are subject to the general 35% withholding tax rate. However,
payments may be subject to a reduced withholding tax rate if services qualify as technical assistance. To
implement this alternative, a formal technical assistance agreement should be signed by the companies. Also
other requirements apply.

Colombia
There are no specific provisions under Colombian law that address the withholding tax treatment applicable to
payments under a CSA. It is treated as if the Colombian subsidiary is paying the home office for an item that
does not represent income for the latter, and is considered income for the party that rendered the service or the
original supplier abroad that contracted with the home office. If this example involved the exploitation of
intangibles, upon making the payment abroad, income tax withholding would be made at a rate of 35% and
7% on the balance for remittance tax (effective rate of 39.55%). However, if the payment corresponds to
services performed outside of Colombia, there will be no withholding tax and, consequently, the expense
deductibility is limited to 15% of net tax income. Software payments are taxed at 80% of each payment
(effective rate 32.04%) and technical assistance services are subject to withholding tax at a rate of 10%.
Administrative overheads are not subject to withholding, but are also not deductible.
In general, payments deriving from CSAs are allowed in Colombia and will be deductible as long as they are
executed in accordance with certain parameters.

Mexico
With regard to withholding tax treatment under Mexican law on payments under a CSA, it is important to
mention that there are no specific provisions and, therefore, taxpayers must determine the nature of the
payment to determine the Mexican tax consequences. In this sense, the payment may be recharacterized as
royalties, technical assistance, or business profits. Its tax treatment will be the same as the one established for
similar payments regulated by domestic tax law or the applicable tax treaty. This tax treatment might differ in
each specific case; for example, if the payment is made for the R&D of intangible properties in a foreign
country, it is very likely that the Mexican authorities would classify this payment as a royalty, and a
withholding tax would apply. As discussed below, the applicable withholding tax may be levied at 10%, 15%
or 40%.
The withholding tax rates applicable to these considerations are: 40% on the gross income in the case of
royalties paid for the temporary use or enjoyment of patents or certificates of invention or improvement,
manufacturer or brand names, and for advertising, and 15% on all other cases of royalty payments. A 15%
withholding tax rate would also apply to technical assistance payments. These payments are a deductible
expense for income tax purposes for the payer. The withholding rate may be 40% in cases where the recipient
is an entity resident in a qualifying tax haven jurisdiction. In this situation, payments will not be deductible in
Mexico unless it can be demonstrated that the price or amount of consideration is equal to that which would
have been contracted by unrelated parties in comparable transactions.

Peru
Under its domestic tax law, Peru imposes withholding taxes on payments of royalties from Peru to non-
residents at a 30% rate.
In general and regardless of whether or not the fees are paid within the national territory, services rendered
totally abroad by non-domiciled entities are not subject to tax in Peru, except in the case of services rendered
by entities located in a tax haven jurisdiction. As of January 1 2001, such service fees will be subject to
income tax (withholding tax), provided they were allowed as tax-deductible expenses for the user of such
services.
Venezuela
A distinction should be made between technical assistance, technological services and ordinary services.
Payments for technical assistance are subject to a progressive rate up to 34% on a notional net taxable income
of 30% of the gross income; thus, the maximum effective tax rate is 10.2%. Payments for technological
services are subject to a progressive tax rate up to 34% on a notional net taxable income of 50% of the gross
income; thus, the effective tax rate could be as high as 17%. For ordinary or conventional services, a
withholding tax of up to 34% is applied if the payment is made to a non-resident taxpayer. If the service
provider is a resident company, the withholding tax is reduced to 2%.

Tax treaty impact

Argentina
Argentina has double tax treaties with 16 countries. Most of these tax treaties expressly include the concept of
technical assistance in their definition of royalties. The double tax treaties generally provide that withholding
tax on technical assistance may be reduced to rates between 10% and 18%. In addition, under certain tax-
sparing provisions, the service provider may be entitled to a tax credit of 20%.

Brazil
The amount of Brazilian withholding tax on outbound service fees may be reduced or even eliminated if
cross-border transactions are structured through a Brazilian double tax treaty. Brazil has concluded more than
22 double tax treaties that contain rules drafted along the lines of the OECD and United Nations Model
Conventions, or that have been introduced especially by Brazilian negotiators.

Chile
Chile has entered into three double tax treaties. The treaty with Argentina provides for zero withholding tax
on payments made from Chile to Argentina when services are rendered in Argentina. Treaties with Canada
and Mexico also provide for zero withholding tax when services are provided by Canadian or Mexican
companies that do not have permanent establishments in Chile. Tax treaties with Canada and Mexico provide
for a 15% withholding tax.

Colombia
Colombia has entered into double tax treaties only with the Andean countries (Venezuela, Ecuador, Peru and
Bolivia). There is no regulation on transfer pricing that could adversely affect agreements and payments
deriving from costs shared worldwide by companies of the same group.

Mexico
It is possible to structure CSAs under the Mexican double tax treaty network to claim the benefits of the
business profits article, and to thereby eliminate the withholding requirements and avoid double taxation. As
long as the consideration is not calculated on a pro rata basis, the payments should be deductible.
The withholding tax rates may be reduced under tax treaties. When the consideration is qualified as a royalty,
a 10% rate is generally applied under a treaty. Technical assistance payments are generally covered by the
"business profits" article, and a withholding tax is not required on these payments.

Peru
At present, Peru is party to only two double taxation treaties. Under an agreement with Bolivia, Colombia,
Ecuador and Venezuela (signatories to the Andean Pact), income earned in those countries is excluded from
taxable income in Peru. Under the tax treaty Peru has concluded with Sweden, tax benefits are available.

Venezuela
To date, Venezuela has concluded double tax treaties with 13 jurisdictions. In some of its treaties, Venezuela
has included within article 12, "Royalties", a provision for taxation at source for technical assistance. Treaties
with this feature include those concluded with: the Czech Republic, Norway, Portugal and Trinidad &
Tobago, with rates of 12%, 9%, 10% and 10% respectively. Under the remainder of the treaties, income
derived from technical assistance should be classified as business profits (article 7), or independent services
(article 14).
Authors
Introduction: Javier Lasso Peña, Ernst & Young's Latin America Business Center, Amsterdam
Argentina: Daniel Rybnik, Ernst & Young's ITS principal, and Gustavo Scravaglieri, Ernst & Young's ITS
manager, Buenos Aires
Brazil: Carlos Romero, director and partner of Ernst & Young´s ITS in São Paulo, Brazil
Chile: Sergio Sapag, director and partner of Ernst & Young´s ITS in Santiago
Colombia: Juan Manuel Idrovo, director and partner of Ernst & Young's ITS in Bogotá, and director of the
LABC in Europe, based in Madrid
Mexico: Federico Aguilar, director and partner of Ernst & Young´s ITS in Mexico D.F., Mexico
Peru: Raúl Piscoya, Ernst & Young's ITS senior manager, Lima
Venezuela: Fernando Fernández, director and partner of Ernst & Young´s ITS in Caracas, and Luis Nouel, tax
manager of Ernst & Young's LABC in Amsterdam