Panama - An Overview of the 2005 fiscal reform

Recently, the Government enacted Law No.6 of 2005 whereby the Fiscal Reform, as styled by the Government, was passed. This law was published in Official Gazette No.25, 232 dated 3rd February 2005. The final version of this Fiscal Reform is in line with the fundamental criteria of territorial taxation applicable in Panama. In other words, income derived from offshore activities will remain untaxed. No tax returns will need to be filed nor will reports to Tax Authorities be required from companies or legal entities carrying out their activities exclusively outside Panamanian territory.

Nevertheless, when it comes to foreign investment within Panamanian territory, the new provisions may create several Income Tax issues for individuals or companies engaged in activities both within and outside the Republic of Panama.

It should also be stressed that the new Fiscal Reform – apart from minor modifications – follows the line of expanding the taxable base concerning indirect taxation advocated in the 2002 Tax Reform. In other words, the inclusion of the “services sector” as part of the taxable supplies subject to Value Added Tax – known in Panama as ITBMS - has remained in the text of Law No.6 of 2005.

Annual Franchise Tax

New Incorporations

Under the new rules, every new company or private foundation will be required to pay a US$250.00 franchise tax at the time its articles of incorporation are filed with the Panamanian Public Registry. Starting from their second year, companies and private foundations will be required to pay a US$300.00 annual franchise tax.

Existing Companies

For existing companies and private foundations, the annual franchise tax will be increased to US$300.00 per year (from US$250.00 per year). Such an increase will become effective as of 1st January 2006. – This means that for the year 2005, all companies and private foundations will pay the current annual franchise of US$250.00.

Payment Periods

The first payment of the annual franchise tax of companies and private foundations will be made at the time of their incorporation. Subsequent payments will be made: (a) on 15th July of every year (for entities incorporated between 1st January and 30th June ) or (b) on 15th January of every year (for entities incorporated between 1st July and 31st December ). Formerly, payments were due on 30th June and 31st December, respectively.

Fines and Penalties

Companies and private foundations that have not paid the respective annual franchise tax for two (2) or more consecutive or alternate one-year periods will be subject to a US$300.00 fine (increased from US$250.00). The penalty for late payment remains at US$50.00 per one-year period.

According to the new provisions, every company or private foundation having ten (10) consecutive delinquent periods will be subject to a statutory dissolution procedure (i.e. the company or private foundation may not continue to carry on with its existence and has to liquidate its assets and liabilities). Such legal entities will be subject to a definitive de-registration at the Public Registry.

Moreover, it is important to note that fines ranging from five (5) to ten (10) times the amount of the franchise tax owed to the Panamanian Treasury will apply for persons (individuals or legal entities) who have received funds for paying the annual franchise tax but have not in fact, settled such sums in accordance with the provisions set forth in the Law.

Income Tax

Income derived from Personal Services (Presumptive Source Rule)

According to the newly introduced Paragraph 1-A of article 694 of the Fiscal Code, income derived from personal services will be considered originated from a source located within Panamanian territory –even though such personal services may be physically and actually rendered both within and outside Panamanian territory - if the individual taxpayer resides in the Republic of Panama for at least 70% of the calendar days of any given year.

The aforementioned rule only applies to income from personal services, such as wages, salaries and other personal remunerations. Therefore, only individuals – and not legal entities of any type- will be obliged to apply this provision. Other income (dividends, pension payments and interest, for example) is not covered by the new rule.

Any individuals rendering services outside Panamanian territory on a temporary basis (for example, consultancy services, professional presentations, conferences and the like) may benefit from exclusion from this presumptive Panamanian source rule. This could be the case even where these individuals do not reach a percentage exceeding 30%, which the general rules requires for reporting foreign source income.

Employment Income (Expense Allowances and Fringe Benefits)

As of February 2005, employees who are paid what is known as Gastos de Representación (or expense-allowance) will be subject to the Income Tax withholding applicable in general terms to salaries and wages. The main difference is that the Income Tax to be withheld from this kind of remuneration will be a fixed rate of 10%. This rule will apply to employees from both the public and private sectors.

Individuals will continue to file an Income Tax return including this specific type of remuneration and assessing the tax due at the progressive Income Tax rates provided for in article 700 of the Fiscal Code.

Moreover, fringe benefits such as housing for company executives or the use of cars, recreation or vacation packages, educational costs and others are now included in the text of article 696 (a) of the Fiscal Code, as specific types of gross income for Income Tax purposes. The only exclusion provided in the Law refers to medical insurance provided by employers to their employees.

The main difficulties relating to the application of this new rule concern the assignment of a specific monetary value to certain fringe benefits and the lack of any schedule or reference in the Law in this regard. So far, Panama’s Tax Administration has specified that fringe benefits will not be subject to the withholding procedures but will be included in the individual tax returns of beneficiaries.

Income earned by Non-residents (The Withholding Mechanism)

According to the newly introduced Paragraph 1-B of article 694 of the Fiscal Code, all payments remitted abroad to beneficiaries not resident in the Republic of Panama shall be subject to Income Tax withholdings if (1) payments are related to the generation of income within Panamanian territory or the conservation of a source of income located within Panamanian territory and (2) the payments are considered to be deductible expenses by the payer operating from Panama.

This provision is not restricted to a specific kind of income. Instead the law specifies that it shall cover all sorts of payments arising from any services or acts, whether documented or not, that benefit individuals or legal entities established within Panamanian territory. As examples, a non-exhaustive list of payments subject to the new rule has been inserted: fees and income relating to intellectual property rights, royalties, know-how, technological or scientific knowledge and the like.


Nevertheless, the taxable base for application of the Income Tax rates (article 699 for legal entities established abroad and article 700 for individuals domiciled abroad) is not the total amount of the payment remitted, but only 50% of such payment.

Last but not least, it is important to stress that Paragraph 1-B of article 694 of the Fiscal Code specifies certain cases where the withholding does not apply. This is the case of individuals or legal entities engaged in “international business activities” and carrying out operations outside Panamanian territory – even if such operations is required to report income originating in the Republic of Panama.

As the provision specifies, this category of taxpayers shall not consider any payments – for goods or services totally financed, contracted or executed outside Panamanian territory – to be Panamanian source income. In other words, such payments will not be subject to any withholding tax.

Several questions remain as to the application of the aforementioned exclusion. What activities may be considered to be “international business activities”? What about services rendered within Panamanian territory but for the consumption and benefit of clients located abroad –no tax deduction attached to such payments-?

We should bear in mind that the provision itself refers to (1) a taxpayer domiciled within Panamanian territory and obliged to report income to the Tax Administration, and not to “pure” offshore activities which are not subject to reporting, and (2) it only requires that certain operations of the taxpayer are carried out outside Panamanian territory – in other words, the provision does not imply that 100% of the taxpayer’s operations are carried out abroad.

As interpreted by certain analysts, this exclusion rule is aimed only at so-called “pure” offshore transactions. I do not agree with this interpretation of the provision since, as mentioned before, the wording of the text refers specifically to taxpayers obliged to report income to the Tax Authorities and that would not be the case of such offshore businesses.

This is yet another issue that the Tax Administration will clarify in the Regulations soon to be issued and published, a situation that is clearly against the principle of certainty and legality that should be the cornerstone of every tax system.

Minimum Income Tax (Presumptive Taxation)

The concept of presumptive taxation is linked to a deviation from material reality and the use of indirect means to determine tax liability, disregarding the actual and concrete situation of a taxpayer. Examples of presumptive taxation can range from the reconstruction of income earned by the taxpayer to true minimum taxes with the tax base specified by the law. The latter (statutory minimum taxable base) was the legislative decision adopted in the new text of articles 699 and 700 of the Fiscal Code.

According to the new rules, the net taxable income of a legal entity will be the higher of (1) the amount resulting from application of the ordinary Income Tax rules (gross income minus deductible expenses minus deductible allowances equals net taxable income), or (2) the amount equivalent to 4.67 % of the gross income earned by the taxpayer. Consequently, in any given case, it may be that the actual net income earned by the taxpayers is far less than the fixed 4.67 % presumptive taxable base set forth in the tax law.

Whenever the effective Income Tax rate exceeds 30% of the net taxable income earned by a taxpayer, a waiver may be obtained from the Tax Administration and no presumptive taxation will apply. The same will apply in the event of losses for taxable purposes. The waiver may be granted for a maximum period of 4 fiscal years (the year for which the waiver is granted and the 3 subsequent fiscal years).

A somewhat similar rule was introduced for individuals earning more than US$60,000.00 per year. Nevertheless, in such cases the statutory presumption does not refer to the taxable base, but the Income Tax itself. The presumptive Income Tax in these cases is set as a fixed percentage of the gross income earned by the taxpayer. As a consequence, it is assumed that the Income Tax liability of individuals will be the higher of (1) their Income Tax liability taxed in accordance with the ordinary rules, or (2) an amount equal to 6% of their gross income earned in a given taxable year.

In the case of individuals, a waiver may be obtained from the Tax Administration only in cases of losses -as determined for tax purposes- but not in cases where the effective Income Tax rate could exceed the tax liability that could have arise in accordance with the ordinary rules.

If a presumptive tax method is adopted, it shall need to take into consideration legal constraints, including constitutional constraints, such as equity before the law and confiscation of property. From the actual application of these new rules, there may be several cases where taxpayers will be taxed on a disproportionate basis owing to the fact that legislative presumptions do not take into account the economic reality of an activity or transaction.

ITBMS Taxation
As mentioned before, the new Fiscal Reform is in line with the expansion of the taxable base in respect of indirect taxation advocated in the 2002 Tax Reform.

Despite several unconstitutionality claims filed with the Supreme Court of Justice in early 2003 –which are still pending a final decision - against the imposition of indirect taxation on fees charged for services rendered by professionals within the Republic of Panama, the inclusion of the “services sector” – including “professional services” among the taxable categories subject to Value Added Tax – domestically known as ITBMS - has remained unchanged in Law No. 6 of 2005.

Minor changes concerning ITBMS taxation are: (1) the inclusion of other tobacco derivatives – besides cigarettes – subject to a higher tax rate of 15%; (2) the exemption of consumption in restaurants that do not serve alcoholic beverages – mainly fast food chains; and (3) a clarification concerning the exemption of export services, specifying that not only “legal” services, but also any other kind of professional services will not be considered taxable items for ITBMS purposes if the beneficiary is a person not resident in the Republic of Panama and not earning any income from any source located within Panamanian territory.

Another aspect related to the application of ITBMS taxation – which has not yet been widely discussed in any forum - relates to the new source rules introduced for Income Tax purposes in Paragraphs 1-A and 1-B of article 694 of the Fiscal Code. Even though it now appears evident that under the aforementioned regulations the range of the concept of “Panamanian source income” has been expanded to cover activities that may be conducted outside Panamanian territory, the consequences thereof are not exactly the same in ITBMS taxation.

Moreover, these are two very different taxes. Each tax is drafted in line with its very own nature and main features. In fact, law provisions applicable to either one are inserted in separate sections of the Fiscal Code. Consequently, each independent set of provisions is not applicable to issues related to the other tax.

Therefore, it may be the case that tax is withheld for Income Tax purposes on the basis of Paragraph 1-B of article 694 of the Fiscal Code, due to the “expanded Panamanian source income” concept. Nevertheless, no ITBMS taxation would be levied since the service could be completely provided from a foreign jurisdiction. As provided for in Paragraph 3 of article 1057-V of the Fiscal Code, taxable supplies are subject to ITBMS taxation only insofar as the supplies are rendered within Panamanian territory. In other words, if the rendering of services is carried out abroad, no ITBMS taxation shall be assessable, even though Income Tax may be assessed on the basis of Paragraphs 1-A and 1-B of article 694 of the Fiscal Code.

Real Property Tax

A new schedule of progressive tax rates applicable to Real Estate property has been inserted as article 766-A of the Fiscal Code. The new tax rates will only be applied to immovable property that has been subject to a new assessment of its cadastral value. The tax rates are as follows:

Regular Tax Rates

1.75% on any value exceeding
US$20,000.00 up to US$50,000.00

1.95% on any value exceeding
US$50,000.00 up to US$75,000.00

2.10% on any value in excess of US$75,000.00

New Tax Rates

0.70% on any value exceeding
US$30,000.00 up to US$50,000.00

0.90% on any value exceeding
US$50,000.00 up to US$75,000.00

1.00 % on any value in excess of US$75,000.00

The main purpose of this measure is to expedite the process of updating the cadastral value of real property in the Republic of Panama. The Ministry of Economy and Finance will review and approve the new value assessed for the property. The period granted for updating cadastral values will end on 2nd February 2006.

Up to 30th June 2005, owners of real estate property may pay any past due Real Estate Tax without any interest or penalty if the requirements as to the new assessment of the cadastral value are fulfilled.

Tax on the Transfer of Immovable Property

All the different kinds of transfers of real estate property will be subject to a 2% tax, including donations or non-onerous transfers. Only transfers between spouses or between parents and children will be considered to be tax free transfers.

The new wording of article 1 of Law No.106 of 1974 poses questions as to the taxability of transfers made under a trust arrangement or under a private foundation charter (when assets are transferred both to or from these separate estates). Even though most of these transfers are made without any intent to obtain profits, the concept of taxing transfers of real property – even without any profitability expectations - does create the need to analyze the tax treatment of these arrangements.

On the other hand, the option of paying a 5% fixed Income Tax rate on any gain arising from the transfer of real property has been removed. Instead, article 701 (a) of the Fiscal Code now provides for a new regime assessing a tax liability at a 10% fixed Income Tax rate, only if one of the following conditions is met: (1) if the immovable property has been one of the owner’s assets for a period of more than 24 months, or (2) if the transaction does not form part of the ordinary course of the owner’s business.

In any other case, the owner of the immovable property will be obliged to pay the Income Tax levied on any gains derived from the disposal of real estate property on the basis of the general rules set forth in the Fiscal Code.

Private Placements of Securities

The Fiscal Reform also modified an exemption relating to a subsidy surcharge (FECI) on credit facilities granted by local banks through private placements of securities issued by their clients. As provided for in the new text, such structured financial arrangements shall only be considered as exempt from the subsidy surcharge (FECI) if the securities issued are registered with the National Securities Commission (Comisión Nacional de Valores).

Recently, the Banking Superintendent issued an administrative circular concerning the Ministry of Economy and Finance’s position as to the obligation of levying the subsidy surcharge (FECI) for private placements subscribed before 3rd February 2005 (the date on which the Fiscal Reform entered into force). As provided for in Circular No. 003-2005 (FECI), the Banking Superintendent submitted that the subsidy surcharge (FECI) is to be assessed only on issuances subscribed on or after 3rd February 2005.

Conclusions

As may be ascertained, the newly enacted Fiscal Reform focuses mainly on changes to the Panamanian Tax System. Therefore, stress has been placed on the analysis of the tax related measures adopted through Law No.6 of 2005.

Many of the issues discussed in this document and several others (such as the elimination of certain incentives for companies protected by the Investment Stability Law – Law No.54 of 1998 - or the application of certain provisions of the law in practical cases) were left unanswered by lawmakers and advisers of the Ministry of Economy and Finance during the process of passing the original bill into law.

As a consequence, many situations will be defined through the Regulations to be issued by the Ministry of Economy and Finance. Needless to say, the limits and criteria set forth in Law No.6 of 2005 shall be observed when drafting the Regulations. Any excess in the regulatory provisions will generate reactions from all sectors of the economy involved. Perhaps the Government will use this interval to receive more feedback from the business community as to the best options for ensuring the application of the law to day-to-day economic activities.

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