This article was originally published in Spanish in Analisis Tributario, Peru by Paul Tadros in 2004 and has not been updated for any subsequent changes. All rights reserved©.

INTRODUCTION
Peru, like most countries in South America, has immense economic potential which could reap substantial benefits to its people. This growth potential is maximized when foreign investment is encouraged. This is not dissimilar to what occurred in countries which are now referred to as “developed” countries. However, like many of its counterparts in South America, it seems to put into place policies and laws which discourage rather than encourage investment (whether foreign or local).

It is recognized that Peru grants a variety of fiscal incentives for specified activities but it cannot rely solely on this method to attract investment. While it provides these incentives, over the last two years Peru: (1) increased its corporate income tax rate; (2) curtailed the utilization of net operating losses; (3) instituted a withholding tax on dividends; (4) instituted “tax haven” rules; and, (5) imposed a withholding tax on digital services.

Stability is one cornerstone of a country’s evolution and, unfortunately, stability in the taxation laws of most South American countries is practically non-existent. To this end, investors tend to look to bilateral and/or multilateral agreements to obtain some measure of stability/certainty. However, this, too, seems to becoming eroded if the Organization for Economic Cooperation and Development (“OECD”) has its way. This is evident from the OECD’s commentary in the January 2003 version of the “OECD Model Convention on Income and Capital” wherein it was stated, in part: “…it is agreed that States do not have to grant the benefits of a double taxation convention where arrangements that constitute an abuse of the provisions of the convention have been entered into” (emphasis added). This is quite an open-ended statement and, notwithstanding the extent to which the OECD went through in justifying this statement, the statement itself is abusive and draconian, to say the least. It is, therefore, obvious that the members of the OECD have no intention of aiding developing countries. As a result, it is incumbent on the countries, like Peru, to resist efforts by these countries to include such draconian provisions in the treaties. One must remember that the OECD member countries are categorized as “developed” and would like to see their high tax bases remain intact.

With the preceding as a background, what can a corporate investor undertake to minimize its taxation risks and create job opportunities and growth in Peru?

The rest of this article examines the income tax treaties (“treaties”) to which Peru is a party.

TREATIES
Background
The discussions hereinafter are intentionally limited in scope i.e. investing into Peru from Canada and the US by corporations.

Other than Mexico and Venezuela, the US does not have bilateral tax treaties with the countries of South America, albeit one is under negotiation with Chile.

Recently, the Peruvian tax authorities have displayed a high degree of aggressiveness resulting in increased litigation with taxpayers. Treaties tend to play a valuable role in curtailing the spate of litigation by placing a “leash” on the aggressiveness which would normally have been displayed by tax authorities.

Peru is party to four treaties: Canada, Chile, Sweden and the multilateral treaty with Bolivia, Colombia, Ecuador and Venezuela (Appendix A). The treaty with Bolivia, Colombia, Ecuador and Venezuela is commonly referred to as the Andean Pact and formally as Decision No. 578 Andean Community of Nations (“CAN”). [For the purposes herein, “Andean Pact”.]

The Andean Pact is a source-based treaty which means that only the country in which the income arises has the right to tax such income. As a result, there is no provision dealing with double taxation and, in essence, avoidance/evasion. The principle of a source-based treaty is best illustrated by an example: a Colombian company conducts a trade or business through a branch in Peru. The income of the branch is taxable in Peru not Colombia notwithstanding that the Colombian corporation is taxable on its worldwide income. As a result, given that the Peruvian income is not subject to tax in Colombia, the income and the branch remittance taxes paid in Peru are not creditable in Colombia. While this is a positive aspect of the Andean Pact, the negative aspect is that the domestic withholding rates on dividends, interest and royalties apply. For dividends and the branch remittance, the withholding rate is 4.1% from Peru while interest and royalties attract a rate of 30% on the gross amount.

The remainder of this article will discuss the treaties between Peru and Canada and Chile.

Discussion
It is important to note that Canada has treaties with two (2) other members of CAN: Ecuador and Venezuela while Chile has one with Ecuador. While these are positive aspects, there are anti-treaty shopping provisions in the following treaties: Canada-Peru;

Canada-Chile; Chile-Peru and Chile-Ecuador. While one can understand the need to have such provisions [for example, in cases where one of the Contracting States has very low rates of taxation (income and withholding)], such provisions limit a country’s scope for attracting investments. This can best be illustrated by an example.

Assume that a US-based company wishes to establish a manufacturing operation in Peru. Invariably, a Peruvian entity would be created to carry on this activity. Absent any planning to minimize any business risks and assuming that the only flow of funds to the US from Peru are dividends, the Peruvian entity can be held directly by the US parent. The dilemma that Peru now faces is that, given its high withholding tax rates on services and royalties, this investment is “useless” if technology/know-how cannot be transferred due to
this high cost. This does not imply that the technology cannot be licensed to the Peruvian entity; it simply means that the payments will be grossed-up so that the Peruvian entity bears the full cost of the withholding. As a result, an element of reduced competitiveness is introduced. Therefore, the US parent has two choices through which to effect the transfer of the technology and the provision of services: Canada or Chile. Given Canada’s high tax rates, the choice becomes Chile.

The provisions of Chile’s holding company regime with its low rate of corporate income tax (currently, 17%) now provides an opportunity for Peru to benefit from the introduction of state-of-the art technology and know-how (services). Pursuant to paragraph 2 of Article 12 of the treaty between Peru and Chile, the maximum withholding tax rate on the royalties would be 15% (versus 30% under Peru’s domestic law). Notwithstanding Peru’s desire to tax services delivered over the internet to Peruvian residents, such services should not be taxable in Peru under subparagraph 3(b) of Article 5 of the Chile-Peru treaty. If the services
are rendered by employees of the Chilean company physically present in Peru, the services should not be subject to tax in Peru if the employees are not physically present in Peru for more than 183 days in any twelve-moth period.

From the preceding, it seems that the US parent is able to achieve its business objective for the investment with benefits (job creation, technology, etc.) to Peru. Of course, this is too good to be true. Both Chile and Peru decided to “shoot themselves in the feet” by introducing uncertainties in their treaty:

1. With regards to the royalties, under paragraph 7 of Article 12, if, in the “eyes” of the Peruvian tax authorities, the main reason for the rights to the intangibles being held by the Chilean company is to obtain the benefits of the lower rate, then the domestic rate of 30% could be applied.
2. If the Peruvian competent authorities believe that the treaty is being “exploited” (again, subjectivity!!), the treaty can be modified (paragraph 6, Article 28).

As a result, one has to ask the following questions:

• To Peru: absent the low labor costs in China, these types of provisions which curtail investments are not in China’s treaties. Therefore, why do they exist in yours?
• To Chile: you created the holding company regime with the desire to promote Chile as the base for expansion into Latin America. What do you then do? Agree to such provisions.

CONCLUSION
While it seems that structuring investments into Peru seem complex and fraught with 
issues, there are other alternatives which have been successfully utilized. While caution and 
prudence are required given that the tax systems may be viewed as a “minefield”, North 
American-based corporate investors should not be discouraged.
One piece of advice to Peru: institute good tax policies to encourage investment and ensure 
that future treaties enhance such investment rather than discourages it.

APPENDIX A
CANADA’S INCOME TAX TREATIES WITH THE ANDEAN COUNTRIES 
WITHHOLDING TAX RATES (%)
The lower rates for dividends apply under specified ownership conditions: Chile, 
Ecuador and Venezuela – the beneficial owner of the dividends must hold at least 25% 
of the voting power of the paying corporation; Peru – the ownership requirement is 
10% under the same conditions.

The lower rates for the royalties apply to certain categories.

1. The rates for dividends do not apply to distributions from Chile to Canada. As long 
   as the Chile’s First Category tax is creditable against the withholding tax, the rate 
   from Chile to Canada is 35%. 
   If Chile subsequently concludes a treaty with an OECD member country and such 
   treaty provides for lower withholding rates with respect to dividends, interest and 
   royalties, such lower rates apply. This is referred to as a most favored nation 
   (“MFN”) clause. However, the MFN does not apply to royalties in respect of 
   software, patents, know-how and certain copyrights.
2. There is a MFN provision vis-à-vis the OECD condition described above for 
   royalties.
3. There is a MFN provision vis-à-vis the OECD condition described above for 
   dividends, interest and royalties.
4. There is a MFN provision vis-à-vis the OECD condition described above for 
   dividends.

CANADA’S INCOME TAX TREATIES WITH THE ANDEAN COUNTRIES WITHHOLDING TAX RATES (%)

Party                                   Dividends              Interest             Royalties
Chile (Note 1)                       10/15                             15                             15
Ecuador (Note 2)                 5/15                              15                         10/15
Peru (Note 3)                       10/15                             15                             15
Venezuela (Note 4)           10/15                             10                           5/10

The lower rates for dividends apply under specified ownership conditions: Chile, Ecuador and Venezuela – the beneficial owner of the dividends must hold at least 25% of the voting power of the paying corporation; Peru – the ownership requirement is 10% under the same conditions.

The lower rates for the royalties apply to certain categories.

1. The rates for dividends do not apply to distributions from Chile to Canada. As long as the Chile’s First Category tax is creditable against the withholding tax, the rate from Chile to Canada is 35%. If Chile subsequently concludes a treaty with an OECD member country and such treaty provides for lower withholding rates with respect to dividends, interest and royalties, such lower rates apply. This is referred to as a most favored nation (“MFN”) clause. However, the MFN does not apply to royalties in respect of software, patents, know-how and certain copyrights.
2. There is a MFN provision vis-à-vis the OECD condition described above for royalties.
3. There is a MFN provision vis-à-vis the OECD condition described above for dividends, interest and royalties.
4. There is a MFN provision vis-à-vis the OECD condition described above for dividends.