Income Taxes

There are two mayor taxes for residents: one for individuals and one for corporations, but some sources of income are taxed separately (schedular system) and only national source income is taxed. As a consequence:

a) The taxed paid on a certain amount of income will be different depending on whether the income was made up from salaries, honoraries for independent professional services, bonds or stock;

b) Major loopholes leave certain sources of income untaxed:

- non - recurrent capital gains are not taxed;

- foreign source income – or national source income “placed” abroad – is not taxed at all;

- it does not tax all incomes of a resident in Costa Rica. This is contradictory to the idea that everyone pays taxes according to his financial capacity, since one is more or less wealthy according to the total of its wealth.

The proposed income taxation imposes a burden on income from labor, professional activities, businesses and capital, either personal or real property, tangible or intangible obtained by a taxpayer on the tax year. Therefore, the project proposes a shift towards global income and unified taxation. This system accumulates all income in one tax basis; it establishes exemption thresholds for individuals and families; medical expenses, rents and residential mortgage interest payments are deductible. Tax rates range from 0 to 30%.

A special tax basis is created for capital gains and losses, which can be compensated and would pay at a 10 % tax rate. This special treatment is justified by the economic capacity principle, due to the irregular characteristic of these gains that normally are generated during

14 Under Costa-Rican law, the bill has to be approved on two separate votes before it becomes law.

several tax periods. Hence, this special basis was created in order to avoid an excessive effect over the progressive scale during the realization year. No special base is retained in the corporate income tax, which becomes truly global. This is reasonable since at corporate level the capital gains are closely tied to the economic activity. In the case of family corporations whose sole purpose is the tenancy of real estate and values, a pass-through regimen is suggested, which means that the individual shareholders could file the tax returns, therefore allowing the special tax base.

Special treatment is give to income from the financial market and from Real Estate Investment Funds. In these cases, a withholding of 10 % could be imposed. Nevertheless, the income will be included in the general basis in order to determine the average in the progressive rate, though it can be deducted an amount resulting from multiplying the total income by the above mentioned average, and not exceeding the total of US $55.000. It is a solution that wants to mitigate the concern of the easy reallocation of this type of income, justifying certain favorable treatment, compatible with a progressive system. At a corporate level, the basic rule applies. Nevertheless, the favorable treatment of 10 % ends at the threshold of US $55.000, since the corporate rate is proportional and not progressive. This rule does not apply for financial intermediation institutions.

The proposal includes the worldwide income taxation model, including some features for the capital gains treatment, according to two distinctions:

a. The source of income, Costa Rican or foreign: if the source of income is Costa Rican it will be taxed on accrual basis. If it is foreign the income will be taxed on cash basis, both for individuals and for corporations. The presumptive income regime provides that the income is presumed as being Costa Rican sourced, except if the taxpayer proves the opposite; it is not possible to defend and unjustified net worth increase with the foreign source income;

b. The registration and filing of offshore capital: its timely compliance allows an identical regime to the one applied to income from the financial market. The lack of compliance allows the general treatment in order to encourage the filing of income from foreign source. This regime applies also the corporations, except in case of financial intermediation institutions, for which the general treatment applies.At a corporate tax level, in case of corporations that own other corporations with a trade or business (not portfolio income) in countries with a corporate income tax, double taxation is avoided by exempting the dividends received by local corporations from foreign corporations.

When dividends are distributed to individuals in Costa Rica, they pay Income Tax on them. Dividends to non residents are exempt, unless they reside in a “tax heaven” .The

exemption method is applicable to avoid international double taxation and includes a prior resignation of the resulting collection between the lower foreign rate and the higher local one, in contrast to the imposition method. In general worldwide income system is usually combined with the imposition method: Spain and Canada, reserve it for business income;

France reserves it for corporate income. In theory, this method promotes capital import neutrality, which means equal treatment to local and external investments in the internal market. If the country is a net capital importer, it will guarantee the avoidance of internal discriminations between foreign and local investment. Nevertheless, if the exporting country taxes capital based on residence, the source country cannot guarantee this neutrality. Due to this, if the country is a capital exporter, it might be interested in encouraging this neutrality so that its companies could compete with the local companies on equal conditions in the source country. If it is like that, worldwide income with the exemption method is the instrument to encourage this neutrality from the country of the residency.

In regards to the integration between the income tax on individual and corporations, as of today dividend income has double taxation, and imposes a 40.5 % total rate: 30 % at a corporate level; 15 % on individuals. This generates a problem of horizontal equity for other incomes: for example, interests can be taxed at 8 % or 15 %. Also, capital gains from the non habitual sales of stock are not taxed. It creates a strong incentive towards debt financing that has been criticized.

The reform proposes that dividends received by individuals should be part of the global income in order to keep the applicable average in the progressive scale, and then it excludes them, since at corporate level the dividends already paid 30 %. If the rate decreases to 25 %, or in cases of a favorable treatment regime (pioneers, minor relative development zones, which would pay 15

%), the payment at corporate level would have a credit in the individual income tax. In the same line, capital gains from the sale of stock would have the same treatment.

It is also important to mention the effect in equity of the potential reduction of the Corporate Income Tax at a 25 % rate. Due to this fact the comparison between the current situation is fundamental. The 30 % of the income tax is applicable to a limited tax base: of the financial or accounting income of a company, one part is taxed at 8 % and the other one at 0 % (except for income from foreign source or non taxable capital gains). With the proposal, the 25

% would be applicable to a wide and uniform base including the income that as of today is excluded. Additionally, it is important to mention that the dividends distribution or the capital gains received by individual shareholder would be taxed in the progressive tax rate on their individual income.

In order to strengthen tax collection, and to compare the situation of the different types of taxpayers with regard to the effective application of the tax, the global imposition on income includes the withholdings on incomes, to guarantee the compliance control. Accordingly, the income payers have the obligation to withhold a tax percentage and then pay it to the Tax Administration. This percentage operates as a tax credit applicable to the taxpayer’s obligation at the end of the period, either by compensation against the tax debt or by claiming a return, if the withholding was higher than the tax obligation. The current income tax legislation contains this system, limited to few hypotheses, such as governmental or other public entities suppliers, with a 2% rate of advance payment.