COSTA RICA: An Introduction to Tax

Costa Rica's Strategic Tax Reforms to Align with International Standard

Costa Rica is undergoing significant transformations in its legislative framework to align with international tax standards and enhance its global competitiveness. Recent developments, including efforts to address the European Union (EU) inclusion of the country in the list of non-cooperative jurisdictions for tax purposes, and the discussions on the adoption and implementation of the OECD's BEPS 2.0 Pillar Two framework, exemplify the country's challenges towards the effective implementation of international tax standards.

This article explores these legislative changes, the challenges they present, and the strategic steps Costa Rica can take to maintain its appeal as an investment destination.

Legislative Actions to Address EU Concerns

In response to the EU's inclusion of the country in Annex I of the list of non-cooperative jurisdictions for tax matters, due to concerns regarding the foreign-source income exemption regime (FSIE), Costa Rica has undertaken significant legislative measures. In October 2023, Costa Rica’s Congress enacted Law No. 10.381, amending the Income Tax Law to exclude the country from the EU's list of non-cooperative jurisdictions for tax matters. This law introduces a tax on certain foreign-source passive income obtained by entities that belong to multinational groups and lack adequate economic substance (non-qualified entity).

Key provisions of the law include:

Clarification of the Territoriality Principle: The law establishes that income from Costa Rican sources is subject to income tax, defining Costa Rican sources as those within the national territory, regardless of whether this passive income is linked to an economic structure or producing source in Costa Rica. The reform has played a key role in improving the clarity of the tax framework and has addressed ongoing discussions between the tax administration and taxpayers regarding the interpretation of the territoriality principle, both at the administrative and judicial levels. Historically, the Costa Rican tax system has been based on the territoriality principle; however, after the failure of the tax authorities to amend the law to implement a worldwide income taxation or at least an extended territorial system, they decided to adopt a broader interpretation of the territoriality principle, incorporating elements not included in the text of the law and allowing them to impose income tax on certain types of foreign-source passive income. Therefore, this amendment to the law clarifies and reaffirms the strict territoriality of the system, except for the newly incorporated exceptions as required by the European Union Foreign Source Income Exemption Regime (FSIE) standard.

Taxation of Certain Foreign-Source Passive Income: As an exception to the territorial regime, dividends, interest, royalties, capital gains, and other passive income from foreign sources will be taxable if obtained by non-qualified entities belonging to a multinational group. To this effect, a multinational group is defined as any company / group that operates in at least two jurisdictions. And a non-qualified entity, is a Costa Rican entity that does not meet the minimum domestic substance requirements as defined in the law and its regulations (e.g. a so called “paper company”) as explained below.

Criteria for Adequate Economic Substance: Entities must demonstrate adequate human resources, strategic decision-making, and expenses incurred in Costa Rica to be considered as a qualified entity and therefore be entitled to benefit from the foreign-source income tax exemption. New regulations have provided specific quantitative and qualitative requisites to meet the substance requirements.

This law was critical in addressing the EU's concerns, which led to Costa Rica's removal from Annex I of the EU's list of non-cooperative jurisdictions for tax purposes as of October 2023.

However, Costa Rica was placed in Annex II of the EU list, pending the country’s implementation of the Global Forum recommendations regarding the automatic exchange of information. These concerns have recently been addressed through Law N° 10.488, enacted in May 2024. The goal is for Costa Rica to achieve the adequate determinations by the Peer Review of the Global Forum and the consequent decision by the EU to remove the country from Annex II.

Adoption and Implementation of BEPS 2.0 Pillar Two (Global Minimum Tax)

Pillar Two, part of the OECD's BEPS 2.0 project, aims to eliminate tax competition based on lower tax rates by ensuring MNEs pay a minimum effective tax rate of 15% regardless of where they operate. This initiative introduces the Global Anti-Base Erosion (GLoBE) rules, which impose a top-up tax on profits that are taxed below the minimum defined effective rate (ETR) of 15% in any jurisdiction. Consequently, this framework can significantly affect tax incentives currently offered by countries (in particular, emerging economies) to attract foreign investment.

For developing economies like Costa Rica, the challenge lies in balancing compliance with these international tax standards while maintaining their attractiveness as investment destinations.

The Costa Rican Context

Costa Rica, like many emerging economies, heavily relies on foreign direct investment (FDI) to fuel its economic growth. The country has established itself as a strategic destination for investors, partly due to its attractive tax incentives under the Free Trade Zone (FTZ) Regime. These incentives have been pivotal in generating employment, fostering economic development, and linking and integrating local businesses into global supply chains.

However, the introduction of Pillar Two presents a dual-edged sword. On one hand, it aims to reduce harmful tax competition. On the other hand, it poses a risk to Costa Rica's competitive edge if the country fails to adapt its tax policies and incentive structures accordingly.

Challenges and Opportunities

One of the primary challenges for Costa Rica is the potential dilution of its existing tax incentives, particularly the existing income tax holiday available to companies operating under the FTZ Regime for specific terms. According to Pillar Two, many tax benefits could be offset by the top-up tax if they result in an ETR below 15%. This could undermine the effectiveness of Costa Rica's FTZ regime incentives and affect the country's ability to attract and retain investments.

To mitigate these risks, Costa Rica needs to proactively adapt its tax policies and redesign its tax and non-tax related incentives to comply with the new rules. It is also crucial for the government to develop and communicate a clear strategy that aligns with the new global tax standards while preserving the country's investment appeal.

Strategic Steps for Costa Rica towards the Global Minimum Tax

To navigate these changes and maintain its competitive edge, Costa Rica should consider the following strategic actions:

Proactive Policy Development and Communication: Costa Rica must define a national policy and a critical path for the implementation of the Global Minimum Tax. This involves transparent communication with stakeholders and careful planning to ensure the country remains competitive. It is important for this approach to provide legal certainty to both existing and potential investors. Preserving the FTZ Regime and at the same time offering new tax and non-tax related incentives to mitigate the impact of increased tax costs, would be essential.

Adopting a QMDTT and Redesigning Tax Incentives: Costa Rica should explore the option of adopting a Qualified Domestic Minimum Top-up Tax (QMDTT) that allows the Tax Administration to collect the top-up tax within the country. But in such case, at the same time, the country must redesign and consider new tax incentives that comply with Pillar Two requirements. This could include Qualified Refundable Tax Credits (QRTCs), which are treated as cash benefits and are not subject to the same limitations as other tax incentives under GLoBE rules. The development of such incentives can help maintain Costa Rica's attractiveness to investors while adhering to international tax standards. Mitigating the impact of any incremental tax cost remains strategic for the competitiveness of the country.

Enhancing Non-Fiscal Incentives: Beyond tax incentives, Costa Rica can also enhance its appeal through non-tax measures such as streamlined regulatory processes, improved infrastructure, and investment in education and workforce development. These factors can create a more attractive overall business environment, offsetting the reduced impact of tax incentives.

Continuous Stakeholder Engagement: Ongoing dialogue with the private sector, particularly industries most affected by the new tax rules, is essential. Establishing technical bodies and joint working groups to monitor global developments and propose adaptive measures can help ensure that Costa Rica's policies remain relevant, competitive, and adequate to meet the needs of companies.

Looking Ahead

Costa Rica's legislative efforts underscore its commitment to aligning with international tax standards and its determination to remain a preferred investment destination. The measures taken to address EU concerns are an example of the crucial steps in securing the country’s compliance with international tax standards.

However, the discussions and potential implementation of Pillar Two represent a significant shift in the global tax landscape. For Costa Rica, this shift brings both challenges and opportunities. By proactively adapting its policies and incentives, engaging with stakeholders, and leveraging international guidelines, Costa Rica can navigate this new reality effectively.

Transforming these challenges into opportunities will be critical for maintaining Costa Rica's position as a preferred destination for foreign investment. With strategic planning and robust policy frameworks, Costa Rica can continue to thrive in an increasingly competitive global market, ensuring sustainable economic growth and development.

In conclusion, Costa Rica stands at a crossroads with the implementation of Pillar Two. The country's proactive stance can set a precedent for other developing economies facing similar challenges. By embracing change and fostering innovation in its fiscal and non-fiscal policies, Costa Rica can secure its future as a competitive and appealing investment destination.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official position of Ernst & Young (EY) or any other organization with which the authors are associated. This content is provided for informational purposes only and should not be construed as legal, tax, investment, financial, or other advice. The information presented here may not be applicable to or suitable for the reader's specific circumstances or needs and may require consideration of other matters. Readers should consult with their own professional advisors before making any decisions based on this information.