New CFC Rules
The income-tax filing season showed, once again, the difficulties of implementing the tax reform. The new rule of article 41G of the Income Tax Law (the “41G”), which taxes Chilean resident owners of a controlled foreign corporation on the CFC’s passive income has generated many practical doubts. Different professionals are applying different criteria. The same is likely to be the case for the IRS’s enforcement bodies.
The typical case is that of an individual resident in Chile (“Juan Manuel”) who has a portfolio of investment in a foreign bank through a foreign corporation or trust (“BVI”). Normally, Juan Manuel will have disclosed the BVI in the amnesty process carried out during 2015 (the “Amnesty”).
Some of the situations that have generated doubts are:
1) Is the income of BVI determined on the basis of full accounting records?
The law provides that the rules on determination of the first category tax base (the corporate tax) should be applied. Most practitioners understand that this does not imply that the BVI must carry full accounting records. A simplified accounting of income and expenditure would be sufficient to allow the determination of a tax base by applying the corporate tax rules.
2) Can losses of Juan Manuel’s direct investments be deducted from CFC income attributed to him in the same year ?
There is no answer in Article 41G nor in the instructions of the IRS. The general rules are contradictory. However, reasonableness and logic indicate that such losses should be deductivle. The main argument is that both should be considered as income of the same species that, having been obtained in the same year, can be offset. A contrary conclusion contradicts with the very definition of “income”.
3) What tax cost should BVI use to determine its capital gains?
Normally, Juan Manuel would have declared BVI’s shares in the Amnesty. To establish its market value, the declaration would have been based on the market value of BVI’s investment portfolio, which was its only asset.
The Amnesty law allows to recognize as tax cost of the declared assets, its market value at the date of the declaration. In our example, the shares of BVI. The rule does not expressly provide for the possibility of transferring the same cost to the underlying assets (ie, the investment portfolio), unless the BVI is subsequently dissolved. Therefore, for each sale transaction in the portfolio, BVI should determine its profit or loss by looking at its historical cost in each instrument, according to the general rules. Certain rulings of the IRS could be read as ratification of this thesis. In my view, the rulings are not sufficiently clear or specific to give them the status of official interpretation on this point.
In any case, this literal rigor is contrary to the spirit and rationale of the Amnesty law. The Amnesty law was established as a single tax and as substitute of any other tax. Therefore, its interpretation should avoid creating instances of double economic taxation, or double non-taxation. Double taxation occurs when the value of the asset when declaring the Amensty was greater than the acquisition cost of the asset; such unrealized gain would be taxed twice. Double non-taxation occurs in the opposite case: The asset had a higher acquisition cost than the market value upon declaring the Amnesty. This implies that Juan Manuel, in the past, had higher incomes that were not taxed under the Amnesty, and can now take advantage of the same loss to lower his tax base of 41G.
The Amensty was a tax that looked at economic substance, ignoring the formal structures. For example, the assets of a trust, legally owned by a trustee, were attributed to the beneficiaries or settlor. Also, the income obtained by companies abroad was understood to be non-compliant, although formally, if they had not been withdrawn, they were not necessarily non-compliant.
Applying consistently the substance of the structures, the cost of acquiring the assets in the portfolio should be the value they had upon declaring the assets for the Amnesty. This, particularly when the portfolio was the direct source of the Amnesty tax base, and the declaration included all the historical background and evolution of that portfolio to establish its origin and traceability. In such cases, it should be understood that, in substance, the investment portfolio is in itself an asset declared in the Amnesty, notwithstanding that for simplicity, only its continent (ie the BVI) could be enunciated in the tax form.
These and other technical doubts were not proactively clarified by the SII nor identified in advance by the advisors to request clarification. They presented themselves in the course of the preparation of the income tax returns. This implies that for tax year 2017 there will be legitimately divergent criteria.