Sep. 26, 2019
The base erosion and profit shifting (BEPS) project developed by the OECD, under the umbrella of the G20, has had a considerable impact on the modifications currently conducted to approximately 250 preferential regimes around the world. This impact comes from peer reviews conducted at the OECD's Forum on Harmful Tax Practices (FHTP) intended to ensure that preferential regimes affecting geographically mobile activity (e.g., service centers, goods distributions centers) that are within the forum's scope comply with the criteria compiled as a minimum requirement in the BEPS Project Action 5.
Although the work conducted by FHTP goes back over 20 years—when the report “Harmful Tax Competition. An emerging global issue" was published in 1998—for the BEPS project, greater emphasis is placed on substance, as reflected in the introduction of the nexus approach for preferential regimes in order to guarantee that the core income-generating activities are performed in the jurisdiction granting the tax benefit. Therefore, the most significant changes introduced in several preferential regimes around the world include the obligation to comply with the new standard on substance.
Another criteria subject to review by FHTP is the elimination of the regimes' ring-fencing features, which for many years characterized preferential regimes (i.e., mainly for regimes that involve the provision of services) in a variety of countries, under the consideration that the tax benefit is only granted when the services are rendered to users abroad. Those countries whose regimes are subject to review by FHTP and that are committed to BEPS' minimum standards have made the regulatory amendments in order to eliminate the ring-fencing elements from their regimes.
Panama's preferential regimes were not immune to this trend, and, at the end of 2018, regulatory amendments were approved to the regime of Multinational Companies Headquarters (SEM) Regime, the Panama Pacifico regime, and the regime of call center activities. A law was issued to incorporate the nexus approach for benefits in the exploitation or transfer of intellectual property.
The amendments made to the preferential regimes, as reflected in the explanatory introduction included in the corresponding draft bills, were intended to adjust them to the minimum BEPS standards; however, other changes related to the regime's competitiveness were included. Hereunder is a brief summary of the main changes in the two regimes—SEM and Panama Pacifico.
Main changes to SEM Regime
The SEM regime in Panama, approved by Law 41 of 2007, which, in accordance with the objective established by said law, is created to attract and promote investment, generate jobs, and promote the transfer of technology and also make Panama more competitive in the global economy through the optimal use of its geographic position, its physical infrastructure, and international services.
Under the regime, a group's headquarter enterprise can provide several services from Panama—contemplated in the law—to the group's member companies (e.g., treasury, technical assistance, accounting, and so on). The regime has tax benefits not only for the companies but also for expatriates, as well as immigration benefits, among others.
This regime has been amended by Law 57 of 2018 and Law 66 of 2018. The main changes related to BEPS refer to new substance requirements that companies with a SEM license must fulfill in order to avail the income tax benefits granted under the regime. These requirements comply with BEPS' standards, considering that companies now need to comply with the execution of the core income generating activities, for which they must demonstrate that they have an adequate number of employees in Panama performing these activities, as well as an adequate amount of operating expenses to conduct these activities, in both cases, based on the nature of the business.
Another change related to BEPS refers to the elimination of ring-fencing, considering that now companies with SEM licenses will have the same tax benefits when they provide services to either local or overseas users. Prior to this change, when services were provided to a local company, said company had to withhold 12.5% of the payment, to the extent that it was deducted as an expense and that, it was related to the generation of Panamanian-sourced income. Whereas when the service was provided to an overseas user, the income was tax-exempted.
The obligation to have a similar tax treatment for local or overseas services led the government to decide to also modify the income tax benefit, eliminating the tax exemption and instead, beginning in 2019, companies with SEM licenses will be subject to a reduced 5% income tax rate, and may credit taxes that would have been applicable (e.g. withholdings) as tax credits; however, in any case a minimum 2% tax rate over the net income would apply. Additionally, beginning in 2019, companies with a SEM license are subject to the transfer pricing regime for their local or overseas operations.
Aligned with these changes, at the end of 2018, the requirements to access the regime have also changed. Resolution 015-2018 was issued on December 28, 2018, and has been in effect since January 1, 2019. Resolution No 20-17 is therefore amended, to establish as requirement to apply for a SEM license, being part of a group with assets equal to or greater than USD200 million or that the company provides services to at least seven affiliates, subsidiaries, or associates.
Following BEPS, companies with a SEM license on the publication date of the first results of the review to the regime (October 16, 2016) have been granted grandfathering to implement the new substance requirements, which expires on June 30, 2021.
Considering that, income obtained by SEM companies is now subject to income tax, under general rules, this would impact other taxes, such as capital gains tax, tax on remittances and dividend tax; therefore the laws issued in 2018 include special treatment and reduced rates.
Main changes in the Panama-Pacifico regime
Law 41 of 2004 creates a special legal, tax, customs, labor, migration and business regime for the establishment and operation of the Panama-Pacifico Special Economic Zone. The Panama-Pacifico area is a 2,004-ha area located a few minutes from Panama City. Although any activity can be performed in the Panama-Pacifico Area, only some of them (listed in Article 60 of the abovementioned law) have income tax benefits, including other tax benefits. The FHTP's reviews focus on geographically mobile activities and activities that require the compliance of standards including substance requirements and the elimination of ring-fencing features, among other aspects developed in the BEPS Action 5 Final Report.
Based on these considerations, it is probable that the amendments made to Law 41 of 2004 only affect some of the activities originally incentivized by the abovementioned Law 41 of 2004, which include services provided to overseas users, office management services provided to overseas users, logistics and multimodal services, call centers, and services related to digital information and applications.
The amendments incorporated by Law 66 of 2018 solve two of the main BEPS issues. The first is the ring-fencing issue, which is removed by eliminating as an incentivized activity under the regime, the rendering of services to overseas users, and by modifying the office management activity so that it can be rendered to local users, using the same tax treatment as to overseas users. To the office management activity is granted the same tax treatment explained in the SEM regime. Companies allowed to perform this activity should comply with the same minimum assets or related entities requirements in order to provide these services, which are required for any company that wishes to obtain a SEM license. Said requirements have been included in Resolution 010-2018.
Panama-Pacifico companies had a 10-year automatic legal stability; therefore, the amendments made to the regime required the consideration of this situation. As stated in the aforementioned Law 66 of 2018, as of the date the law entered into force, companies with legal stability can maintain their income tax exemption for the services or office management services provided to overseas users; however under this scenario, they are granted the same exemption when the services are conducted in the local market, removing the ring-fencing issue in the regime. However, in the rendering of their services to the local market, said companies are required to pay VAT.
In terms of the substance BEPS standard, Law 66 of 2018 amends Law 41 of 2004 with purpose to include the requirement to conduct the core income generating activities within Panama (Article 3, paragraph 22, Law 41 of 2004), and accordingly, the company should have an adequate amount of full-time qualified employees and an adequate amount of operating expenses (article 60-A of Law 41). Additionally, reporting obligations rules related to these substance requirements are included, facilitating compliance monitoring.
As in the SEM regime, companies under the Panama-Pacifico regime as of October 16, 2017 have been granted grandfathering to implement new substantial requirements to the activities to which these requirements are applicable. The grandfathering term expires on June 30, 2021.
The changes we have observed in Panama's regimes are occurring worldwide. The Costa Rica Free Trade Zone regime, the Uruguay's Service Center, and Free Trade Zone regimes are examples from neighboring countries. Since last year, the new substance standard has been required in jurisdictions with no income tax or nominal income tax, which include the British Virgin Islands, the Cayman Islands, and Bahamas, which recently issued their legislations regarding this topic. Panama's preferential regimes maintain their competitiveness without failing to comply with international standards to which the country has been compromised.