Funding your Chilean Subsidiary – Debt vs Equity
Foreign companies who establish a subsidiary in Chile need to decide on how they will fund the new operation. In most cases, companies will use internal financing since external financing from banks is generally quite difficult to obtain.
This is a particularly important issue for companies since funds entering the country from day one will need to be recorded in the accounting books and registered with the Chilean central bank.
There are two ways to fund a company’s growth in Chile. The first is in the form of equity. The second is through loans (debt). There is also the option to use a combination of the two.
The differences between the two options will depend on the size of the operations to be developed in Chile, the overall vision of the business that the owners have, and lastly, Chilean tax law that regulate both options.
FUNDING THROUGH EQUITY – The money sent from the parent company to Chile could be registered as equity.
The capital may be paid in (registered) during the incorporation process as initial capital and another part in a period not exceeding 3 years. Alternatively, in a period that is agreed on in the bylaws of the company.
It is important to remember that in Chile, the cost of the business license is directly related to how much capital is registered as equity in the company. Increasing the capital of the company will mean that the business license that is paid each year will increase as well.
Each city government determines the rate of the municipal of the municipal tax. The range of the applicable rate fluctuates between 0.2% and 0.5% of the equity registered in the company.
The disadvantage with equity is that it limits future tax planning strategies since profits generated in the future would be repatriated generally to the parent in the form of dividends.
FUNDING THROUGH LOANS – A company could fund its subsidiary through loans between the related entities with some safeguards that we will explain below.
Intercompany loan agreements are a standard tool across the world with small variations depending on the legal and accounting system used in the respected country. In general, the issue with intercompany loans and taxes is that while the company may consider it a loan, government agencies may view it as an equity investment. Intercompany loans must be conducted at arm’s length with a clear loan agreement to demonstrate that it is a loan within the company, not a movement or investment of capital, and the borrower has an obligation to repay it at set terms.
The loan will be subject to the payment of an interest rate. The interest paid on a loan granted from abroad shall be subject to the payment of withholding tax. If the beneficial owner of the interest is a resident of a country with which Chile has a Double Taxation Agreement, then the WHT rate is 10% on the interest.
Loans have some tax planning advantages such as being able to repay the principal amount with no withholding tax. The disadvantage is that they are regulated and there are some important considerations which we cover below.
ASPECTS TO CONSIDER ABOUT LOANS:
i. The loan must enter Chile through the Formal Exchange Market such as Banking or Financial Institutions.
When the money enters Chile, the concept of remittance must be indicated with the financial institution, noting that it is a loan from abroad in favor of the Chilean company. In turn, the commercial bank will inform the Chilean Central Bank.
ii. Loans should be well documented with written loan agreements between the related parties. In this sense, under the rules that regulate this matter in Chile, we can point out that when a loan is granted, the application of the Stamp Duty, hereinafter “ITE”, is immediately triggered,
The law that regulates ITE taxes on loans granted from abroad expressly stipulates that credit operations from abroad in which no documents have been issued or subscribed, the ITE tax will be levied when they are accounted for in Chile.
- Generally speaking, documented loans and undocumented foreign loans are subject to a monthly stamp tax duty at 0.0066% with a cap of 0.8% (0.066 *12).
- This tax is imposed on the loan principal indicated in the document (interest are levied apart). For loans with no maturity date, payable on-demand, the tax increases up to 0.332%.
THIN CAPITALIZATION RULES
In addition, we must consider the control rules established in the ITL art. 41F, known as thin capitalization rules. This rule states that the ratio of the debtor company’s net worth to the loan granted cannot exceed the ratio of 3 to 1.
This means that the entity that receives the loan cannot borrow more than three times its capital. In other words, if the debtor company is in debt by more than the ratio of 3 to 1, on all amounts constituting over-indebtedness, a rate of 35% WHT, regardless of a double taxation agreement in place would apply.
It is important to note that debt can be capitalized at a future date should a company find itself in this situation.
TRANSFER PRICING RULES
Finally, we must not forget the existence of transfer pricing rules (TP) that apply to cross-border and related party transactions.
The terms on which the loan is agreed should be considered at market values or under the premise of “Arm’s Length”, considering an interest rate and other mutual terms that unrelated parties would agree on similar terms.
The loan must comply with the “Arm’s Length” principle as if a third independent party had given the loan. This also suggests that it is prudent to indicate an interest on the loan, especially, if there are large amounts involved.
The most prudent way to set prices is through a transfer pricing report. If there is no transfer pricing report then there is a risk that the Chilean tax office could dispute the interest rate used creating a tax contingency for the company.
Both debt and equity have positives and negatives. Loans can eventually be repaid with no withholding tax on the principal once the subsidiary is profitable, but it also requires companies to pay stamp tax and have a procedure in place to document the loans.
Equity on the other hand is quite simple to record in the accounting books but the disadvantage is that it limits future tax planning and directly effects how much the company pays for its municipal business license.
In most cases, companies will use a combination of debt and equity to finance the Chilean subsidiary. The mix of the two will often depend on the financial policies of the company, the projection of the business in the short and medium term, and the tax laws of the countries involved.
What is important is that companies discuss this topic at an early stage of setting up their subsidiary since the funds entering the country need to be recorded correctly in the accounting books and registered with the central bank.
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