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.
