Pacific Alliance double taxation avoidance convention enters into force
The Convention to Homologate the Tax Treatment provided for in the Conventions to Avoid Double Taxation entered into between the States Party to the Pacific Alliance Framework Agreement (the Convention) has entered into force between Mexico, Colombia, Peru, and Chile.
The four Pacific Alliance membership countries (collectively, the States) first entered into the Convention in October 2017, in an effort to amend the bilateral agreements for the avoidance of double taxation between the States (Covered Agreements) and grant resident status to pension funds within each country.
The Convention also aims to standardize the tax treatment of interest (including income derived from the sale of debt securities issued by a resident of a State party to the Convention) and capital gains (i) derived from the sale of shares, (ii) through a stock exchange that is part of the Latin American Integrated Market (MILA), and (iii) obtained by the pension funds mentioned in Article 4 of the Convention.
Such standardization will result in a lower tax burden for the recognized pension funds, which benefits the fund users (but not those who manage the funds).
In light of the pension funds’ resident status, all distributive rules for other types of income (eg, dividends) will be applicable to those funds. It is important to note that the Convention establishes that, if under any current treaty there is a lower taxation for any particular income, that treatment will prevail and must be applied for the treaty in question.
The Convention entered into force after the completion of local procedures and notifications to the Depositary (ie, Colombia) without prejudice to its specific applicability in such jurisdictions, which we outline below.
By virtue of the foregoing, the following will be amended:
- The Agreement between the Republic of Chile and the United Mexican States to Avoid Double Taxation and Prevent Tax Evasion in Income and Wealth Tax Matters, signed on April 17, 1998
- The Agreement between the Republic of Colombia and the United Mexican States to Avoid Double Taxation and to Prevent Fiscal Evasion with Respect to Income and Wealth Taxes, signed on August 13, 2009
- The Agreement between the Republic of Peru and the United Mexican States to Avoid Double Taxation and to Prevent Fiscal Evasion with Respect to Income Taxes, signed on April 27, 2011
- Decision 578 of the Andean Community of Nations, signed on May 4, 2004
- The Agreement between the Republic of Chile and the Republic of Colombia to Avoid Double Taxation and to Prevent Fiscal Evasion in Relation to Income and Wealth Taxes, signed on April 18, 2007, and
- The Agreement to Avoid Double Taxation and to Prevent Tax Evasion in relation to Income and Wealth Tax, signed on June 8, 2001.
The Convention’s key impacts on each jurisdiction are outlined below.
In Colombia, pension funds are not income taxpayers. Therefore, in principle, pension funds do not qualify for access to the differential treatments established by certain double taxation avoidance treaties signed by Colombia. However, the Convention’s entry into force removes this limitation, as it specifically recognizes pension funds as covered persons and as effective beneficiaries of the income they receive.
It should be noted that, in the case of Colombia and Peru, Decision 578 of the Andean Community of Nations (CAN) establishes a preference for taxation at source as well as an exemption system within the country of residence, which represents a significant change within the taxation rules under such agreement. With this, in Annex I, the provisions of the Convention are treated separately for both countries.
Treatment of interest in the bilateral agreements in force between Colombia, Chile, Mexico, and Peru
For non-residents in Colombia, in the absence of a double taxation avoidance treaty to the contrary, interest is subject to a withholding tax of 15 percent, if the term of the loan is at least 1 year, or 20 percent otherwise.
Colombia-Chile Covered Agreement (Article 11)
The current Agreement establishes two rates: one of 5 percent, when the creditor is a bank or an insurance company, and one of 15 percent, for all other cases. The Convention does not affect the former rate; however, the latter will be reduced to 10 percent, in the case of pension funds.
With respect to the disposal of debt securities that, according to the Convention, are considered within the definition of interest in Chile, it may be possible to apply the provisions of the Capital Gains Convention, which establish that such income would be taxed only in the country of residence. This is relevant because the Convention indicates that, if there is a lower taxation for a specific income under the current treaty, that provision should be applied.
Colombia-Mexico Covered Agreement (Article 11)
The current Convention establishes two rates: one of 5 percent, when the creditor is a bank or an insurance company, and one of 10 percent, for all other cases.
Additionally, the Convention outlines some exceptional events in which interest is not taxed in the source country, such as in the case of interest paid by certain public, financial, or investment entities, or when the creditor is a State, a political subdivision, a local or territorial entity, or the central bank. However, the Convention would not affect these cases, as pension funds do not fall within these exceptions.
Thus, the Convention does not grant a benefit on the withholding tax rate in a source country that is different from the one previously considered in the Convention between both countries.
In Mexico, as in Chile, discussion could arise with respect to the disposal of debt securities, which would be taxed under the Convention as capital gains, subject only to taxation within the country of residence.
Colombia-Peru Covered Agreement (Article 10)
Article 10 of CAN Decision 578 states that interest will only be taxed in the country within whose territory its payment is imputed and recorded. Under this assumption, the country of residence must treat this interest as exempt income.
In the cases of Colombia and Peru, the Convention establishes that interest paid to a pension fund of the other Contracting State may be subject to taxation within the State of residence, without limitation – and, within the State of source, tax may not exceed 10 percent.
With this, the Convention departs from the rules of Decision 578 of the CAN by limiting taxation in the State of source and allowing taxation within the State of residence. According to Article 9 of Annex 1, the State of residence must grant a tax credit for the tax paid within the State of source. However, it is important to note that, in Colombia, because pension funds are not considered taxpayers, there may be no tax credit if a tax is levied in Peru.
In Peru, dividends, interest, and capital gains are not taxable for pension funds. For this reason, the referred credit for withholding applicable in Colombia may not be applicable in practice due to the quality granted to this type of taxpayers.
Additionally, the Convention establishes that, when the debtor is a Contracting State; a political subdivision; a bank, if 100 percent of its capital is owned by one of the States; or the central bank, interest will only be taxed within the pension fund’s State of residence.
The Convention’s validity
In Colombia, the Convention will apply starting on January 1 of the calendar year immediately following that in which the Convention enters into force. In other words, these provisions will be applicable from January 1, 2024.
In Chile, recognized pension funds are those established in accordance with the pension system of Decree Law No. 3,500. Pension funds recognized in Chile are not subject to income tax. Therefore, interest or capital gains received from abroad will not be taxed by the country. With this, it may be important to note that the Convention limits the taxation of this income in the country from which it is remitted to Chile.
On the other hand, in general, interest that an entity resident in Chile pays to a creditor resident abroad is subject to a 35-percent withholding tax (Impuesto Adicional). However, interest from credits granted from abroad by foreign pension funds may qualify for a special additional tax rate of 4 percent, provided that they meet the legal requirements set forth in the Chilean Income Tax Law.
If the interest is paid as a return on another instrument or transaction, or if the foreign pension fund does not meet the legal requirements, the domestic rate of 35 percent may be limited to 10 percent under the Convention.
Treatment of interest in the bilateral agreements in force between Chile, Mexico, Colombia, and Peru
Mexico-Chile Covered Agreement (Article 11)
The rate of Withholding Tax in the source country of the interest is limited to:
- 5 percent for interest on loans granted by banks
- 10 percent for loans granted by insurance companies; interest derived from bonds and securities that are regularly and substantially traded on a recognized stock exchange; and interest derived from credit sales granted to the purchaser of machinery and equipment, by the beneficial owner who is the seller of the machinery and equipment, and
- 15 percent in all other cases.
Consequently, recognized pension funds that receive interest could benefit from the 10-percent rate limitation established by the Convention. However, treatment under domestic law in either Chile (4-percent withholding) or Mexico (where they would not be subject to withholding) would continue to be more beneficial, subject to compliance with local regulations.
Entry into force
The Convention enters into force 60 days after the last notification is received by Colombia, the Depositary. However, its provisions regarding taxes on interest and capital gains earned and amounts paid, credited, made available, or expensed will apply in Chile as of January 1, 2024.
On April 26, 2018, the United Commissions of Foreign Affairs Latin America and the Caribbean; Foreign Affairs; and Finance and Public Credit, of the H. Chamber of Senators, of the Congress of the Union, jointly ruled on the draft decree and unanimously approved the Convention.
In any case, references to persons in such agreements will be understood to include pension funds. In addition, in the specific case of Mexico, it will include the Investment Companies Specialized in Retirement Funds (SIEFORES) established in accordance with the Law of the Retirement Savings Systems.
It is important to consider that, in accordance with the Income Tax Law, pension and retirement funds that are effective beneficiaries of interest income, capital gains, and the granting of the temporary use and enjoyment of land and buildings will not be subject to withholding on income from sources within Mexican territory.
The provisions of the Convention are due to enter into force on January 1 of the calendar year immediately following the one in which the Convention enters into force – that is, January 1, 2024.
The Convention can be found here. For more information, please contact the authors.
Read this article in Spanish.