Chile Anti-Avoidance Rule Succeeds in Court but Faces Challenge

Chile’s general anti-avoidance rule debuted in Forestal Aurora SpA v Servicio de Impuestos Internos, the first Chilean judicial ruling on the GAAR.

Former President Michelle Bachelet enacted the Chilean GAAR in 2014. Since then the Chilean tax administration, or SII, opted to create a catalog of 85 operations potentially subject to the GAAR and has reviewed over 94 requests of opinion into whether certain “hypothetical transactions” could be called into question under the rule.

Until this case, the SII had not been able to successfully use the GAAR in court. However, with the March 19 ruling by the Bío Bío regional tax court, everything changed, and the GAAR was finally invoked successfully against a taxpayer in court.

The ruling calls into question the use of debt funding by multinational groups, and the taxpayer has already lodged an appeal before the Concepción Court of Appeals.

The Case

The case involved a taxpayer operating in the forestry sector with a foreign shareholder that had opted in 2016 to fund it through both equity and debt.

Interest payments paid to foreign creditors generally are subject to a 35% withholding tax, unless a tax treaty is in effect reducing the burden, typically to 10%. An exception provided by Chilean law benefits interest paid to foreign banks, insurance companies, and foreign financial institutions, or FFIs, by reducing the applicable withholding tax rate to 4%.

The foreign shareholder in this case opted to create a foreign subsidiary, voluntarily register it with the Chilean tax administration as an FFI as per the requirements in the administrative regulation, and channel debt funding through it to the Chilean subsidiary.

As in most jurisdictions, related party debt funding is highly regulated from an expense deductibility, thin capitalization, and transfer pricing perspective.

This funding structure meant that the interest expense had to be made in connection with the business activity of the Chilean subsidiary, for example, to fund acquisitions; that the 6.5% interest rate being charged on unpaid principal over a 16-year period met the arm’s length transfer pricing principle; and that the debtor maintained a maximum level of debt versus equity of 75%/25%, in order for the interest payments to benefit from the reduced 4% withholding tax rate.

The successful use of the GAAR in this case suggests that the taxpayer met all the requirements under the expense deductibility regulation, thin capitalization regulation, and transfer pricing regulation, and that the SII was going after the applicable withholding tax rate per se.

The SII’s argument was clear: creating an FFI with the sole purpose of taking advantage of the 4% withholding tax rate is unlawful, even if the FFI was duly registered and recognized by the tax administration.

The taxpayer argued that such a structure was within the possibilities allowed under Chilean law, and there were specific rules to regulate it. Otherwise, what was the purpose of a thin capitalization rule on related debt funding benefiting from a reduced withholding tax rate?

Court Ruling

The tax court accepted 100% of the argument presented by the SII. The court declared that the consequences derived from this debt funding were “repugnant” to the Chilean legal system since what was obtained by the local entity was “not debt but working capital,” and that the payment of interest clearly resulted in an artificial way of lowering the entity’s withholding tax burden.

The court continued to argue its disapproval for debt funding by saying that without this structure, the foreign shareholder would have had to contribute directly to its Chilean subsidiary, and any payment to it—via dividends or regular interest—would have been subject to a 35% withholding tax.

Case Impact

Debt funding is typically preferred to equity funding because of its flexibility and undeniable tax benefits, which explains why it is highly regulated by the elected Chilean Congress.

Congress has discussed several comprehensive tax bills since the Chilean GAAR was enacted, but none attempted to touch or mitigate the extent to which related party debt funding could be used, apart from a 2020 regulation that highlighted the requirement of substance for an intra-group FFI.

Hence, the problem with the debut of the Chilean GAAR isn’t its use per se as a means of requiring substance, but that a specific funding strategy regulated by the Chilean Congress was disregarded by a judge that seemed to favor equity contributions over shareholder debt funding, even if the latter was allowed by law.

The use of treasury entities by multinational groups such as mining companies is undeniable and transparent to the SII, as shown by a review of the public registry of FFIs. The reason for that transparency isn’t a moral virtue of such foreign investors, but rather the consequence of a highly regulated scheme in Chilean tax law.

The Concepción Court of Appeals will now have to decide not simply whether the use of the GAAR in Forestal Aurora SpA was lawful but also whether the use of debt funding as a widely used practice by multinational groups, specifically regulated by tax law, is permissible at all.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Ignacio Gepp is partner with Puente Sur in Chile.

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