With increased tax regulations and scrutiny from the world international governing bodies, substance has become the new normal in terms of satisfying the criteria to achieve tax residency.
Considerable pressure from the Organization for Economic Co-operation and Development (OECD) has forced jurisdictions to implement economic substance requirements to combat international tax abuse. Entities are required to display the economic reality of their structure and demonstrate that their core operating activities are being conducted in the country where they are incorporated and/or seeking to derive tax treaty benefits. Residency is a key feature in international taxation and fundamental for its application to tax treaties and laws. The OECD outlines the potential impact of tax residency and in case an entity is tax resident in another jurisdiction, it may be subject to taxation in that jurisdiction even if it is incorporated elsewhere. The substance requirement is established in Action 5 of the OECD/G20 Base Erosion and Profit Shifting Project (BEPS) and Panama has embedded these requirements in its Income Tax legislation. In a nutshell, for an entity to satisfy the economic substance requirements. it must:
1. Carry its core income generating activities in Panama.
2. Employ, directly or indirectly, an adequate number of suitably qualified persons.
3. Incur a minimum level of expenditure proportionate to its level of activities.
Core income generating activities relate to the key necessary and value-added activities that generate the income of the entity. These activities must be carried out and performed in Panama and the majority of the board of directors involved in strategic decision making must be present in Panama when decisions are made.
For instance, in case of an investment management entity providing advisory services to a fund in Panama, this particular service will have to be rendered in Panama and the entity shall adhere to the substance requirements conditions.
Tax resident entities in Panama must be effectively managed and controlled in Panama. Consequently, a quorum of Board of Directors must be required to be physically present in Panama at a suitable frequency when strategic decisions are being taken and the minutes of meetings must be properly kept demonstrating these decisions together with the major documentation required by the Board of Directors. The relevant knowledge and expertise of the Board of Directors will need to be considered considering the activities carried out by the entity.
The good news is that an entity may opt to outsource or contract out its activities to third parties service providers, however these services should be provided in Panama and include specific details of the person(s) employed by its service providers. The assessment should consider the qualification and experience of persons who are involved in providing the core income generating activities. Panama is an ideal choice for investors as it is an IFC of choice and excellence with a collection of financial services providers which include management companies who has substantial experience in providing professional services to global business entities.
However, the COVID-19 crisis may pose challenges in respect of the place where the entity is effectively managed and controlled due to travel restrictions and inability of senior executives to travel.
The OECD has clarified that it is unlikely that the COVID-19 situation will create any changes to an entity’s residence status under a tax treaty since it constitutes extraordinary and temporary circumstance that should not give rise to a change of a company’s residence for tax purposes.
With unprecedented challenges and uncertainty facing the world and aid budget under pressure, the new substance requirements will promote tax fairness and reduce inequalities by ensuring a fair distribution of wealth which will lead to more sustainable development.
In Panama, tax residence is regulated by Executive Decree 958 of 2013 and Resolution 201-0354 of 2016.
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