Paraguay has a tax system characterized by low rates and special tax incentive regimes aimed to benefit capital investments. According to the Organization for Economic Co-operation and Development (OECD), the ratio of tax revenue to GDP in Paraguay was 13.8% in 2017, the lowest in South America, where the average is 23.53%.
The current Paraguayan tax system, however, is extremely regressive. Almost 60% of the tax revenue comes from indirect taxes, which are value-added tax (VAT) and excise tax. As of today, the most relevant income taxes are:
- income tax on commercial and industrial activities and services (IRACIS, per its Spanish acronym); and
- income tax on agricultural activities (IRAGRO).
The current system is about to change.
On June 19, 2019, the Senate approved a bill that substantially modifies the current tax laws. On July 10, 2019, the House of Representatives began the analysis of the bill, and if approved, the President will veto or confirm it. Once the new tax law is enacted, it is expected to enter into force within 90 days of its enactment.
The tax reform is not designed to drastically increase the tax burden of the country. Its main goals are a shift in the composition of the tax revenue collected from indirect to direct taxes and to simplify current rules on income tax.
The amount collected in taxes is expected to increase by $300 million (263 million euros) per year once the tax reform comes into full force. This will represent a 10% increase in revenue collection with respect to the general budget of Paraguay.
The reform contemplates the creation of three new income taxes based on IRACIS and IRAGRO rules. The new taxes are:
- corporate income tax (IRE);
- tax on dividends (IDU); and
- tax on nonresidents (IRN).
How will the IRE Change the Scenario?
The IRE will replace current income taxes IRACIS and IRAGRO and borrows many of the rules currently applicable to such taxes. As of today, the Paraguayan tax system adheres to the principle of territoriality of the source with a few exceptions.
Under the IRE, the worldwide system applies, meaning that Paraguayan tax residents are liable to tax in Paraguay on income generated outside Paraguay. This shift will represent a challenge for the Paraguayan government, which will need to increase its efforts to facilitate the signing of bilateral treaties in order to avoid double taxation. As of today, Paraguay has only one double taxation treaty in force, with Chile.
The current IRACIS and IRAGRO have a general tax rate of 10% applicable over net income but only IRAGRO allows taxpayers to carry forward losses. IRE will generally contemplate loss carry forward rules, which will be more beneficial for businesses prone to taking risks.
Are International Rules Introduced?
Paraguay has no transfer pricing or thin capitalization rules.
With the new tax law, transfer pricing and thin capitalization rules will be applied for the IRE assessment. Regarding transfer pricing rules, the IRE bill will adopt the OECD recommendations to determine the market value of the transaction. In addition, the bill maintains a price control system for the export of commodities such as soybeans, based on the market value determined by international prices.
The bill also introduces clear parameters to define related parties in order to apply the transfer pricing rules.
Furthermore, a legal presumption of relatedness is established, providing that the parties of an operation are related if one of them is resident in a country or jurisdiction of low or null taxation. The bill provides that a future regulatory decree will define which countries or jurisdictions are deemed “of low or null taxation.”
Thin capitalization rules are also introduced in financing and day-to-day operations carried out between related parties. The bill approaches this issue by limiting deductibility of interest, fees for technical assistance and royalties paid between related parties, to a ratio of 30% in regard of the net income of the entity that is making the payments. Therefore, the amount paid that exceeds this limit will not be deductible under the new law.
How will Dividends be Taxed?
IRACIS current effective rate for distribution of dividends to a parent shareholder abroad is 27.32% over net income remitted. Under IRAGRO, the effective rate is 23.5%.
If the current bill is approved, foreign investors will benefit since the maximum effective tax rate on the net income obtained by foreign investors will be 23.50%, which represents a decrease in the current tax burden for foreign investors who receive dividends from Paraguayan companies that previously paid the IRACIS.
How are Nonresidents Affected?
Currently, under IRACIS rules, the law imposes tax withholdings on services provided or exploited in Paraguay by entities that are not considered Paraguayan tax residents. The withholding tax rates can range from 3% to 30% of the gross amount received by foreigners, depending on the type of income or on the relationship between the parties.
The new withholding rules under the INR are similar to those contemplated by the IRACIS that provide a legal presumption that the net profit of nonresidents is a percentage of the gross income obtained according to the connection points.
The INR represents a slight increase in the tax burden for some international operations, like freight services, digital services and services provided by insurance companies, but at the same time, it denotes an important reduction for others, since the maximum effective rate for this tax was reduced from 30% to 15%. In summary, the INR represents a decrease of 50% in some withholdings that affect nonresidents, for the income obtained in Paraguay.
How will the Bill Change VAT Treatment?
Although the bill is mainly aimed at increasing collection of direct taxes, the law also introduces substantial changes to VAT. These changes will also have an impact on direct taxes. Currently, 50% of the VAT credit obtained in the purchase of raw materials is reimbursable for the exporters of unprocessed agricultural products or products with basic industrial processing (e.g. raw flour or oil, not fit for human consumption).
The bill provides that the VAT fiscal credit obtained from the purchase of agricultural raw materials may no longer be reimbursed, in cases where goods are exported without industrial processing. Consequently, the VAT credit will represent a new cost for the exporters of agricultural raw materials. Since this will now be an expense, payment of such VAT may still be used as a deductible cost for the assessment of the IRE.
Through this provision, the government expects to increase the revenue collection by approximately $100 million.
The bill introduced by the Ministry of Finance is intended to make a shift in the composition of the public revenue from indirect taxes to direct taxes and is highly likely to be approved in the coming weeks, which will be a major shift for a system that has been in force since 1992.
Innovations contemplated by the new tax laws are transfer pricing and thin capitalization rules.
Notwithstanding the reform, a major challenge for the government will be to strengthen its ability to enforce current and prospective tax laws in order to increase collection efficiently. Without good enforcement, the new tax rules will have little impact on the social and fiscal goals intended by the government.
To prepare for this reform, taxpayers can plan the course of action and rearrange their activities in order to comply with the provisions of the bill. The relatedness between companies of the same group should be addressed, since transfer pricing rules will apply to the transactions conducted between companies that qualify as related parties according to the bill.
A good option for exporters of agricultural products will be to industrialize or process at least part of the raw material in Paraguay, before export.
Erika Bañuelos is a Senior Associate and Horacio Sánchez Pangrazio is an Associate at Ferrere, Paraguay