COSTA RICA: An Introduction to Tax

Navigating Costa Rica’s Tax Landscape: FSIE Reform, Pillar 2 and the Consolidation of Public Finances

Introduction

Costa Rica’s last comprehensive tax reform, implemented in 2019, introduced material changes that reshaped the country’s fiscal framework. A significant outcome was the replacement of the sales tax with VAT, alongside updates to the income tax system. These adjustments aimed to modernise taxation and enhance compliance. Since then, the administration has sought to introduce further reforms aimed at achieving simplification, efficiency and alignment with revenue collection. Among these proposals were attempts to transition from the territorial tax system to a worldwide income taxation model, and to unify the existing schedular income tax structure into an integrated global tax system.

Despite their ambitious goals, these reform efforts encountered considerable resistance. Controversial elements, such as introducing worldwide income taxation, sparked debate in Congress and among stakeholders, leading to their rejection. However, the administration succeeded in passing several targeted reforms that have significantly impacted Costa Rica’s approach to international tax policy and foreign direct investment.

A pivotal development in 2023 was the amendment to Costa Rica’s foreign source passive income regime (FSIE). This reform aligned the country’s tax system with international standards and facilitated Costa Rica’s removal from the EU’s list of noncooperative jurisdictions. While this achievement marked progress, ambiguities in the practical application of these changes persist. Concurrently, global initiatives like the OECD’s Pillar 2 global minimum tax present both challenges and opportunities, particularly concerning Costa Rica’s free trade zone regime (FTZR).

This article examines the recent tax reforms, explores the evolving role of the tax administration and evaluates Costa Rica’s position amidst global tax policy shifts.

The 2023 reform of the FSIE

The reform of Costa Rica’s FSIE regime was a watershed moment, addressing long-standing issues and aligning the country with international tax standards. The administration initially leveraged EU requirements to propose comprehensive changes, including worldwide income taxation for individuals and businesses. Congress, however, opted for a more measured approach, passing amendments focused on compliance with EU standards and resolving disputes between the tax administration and taxpayers.

Enacted in October 2023, the reform reaffirmed Costa Rica’s commitment to the territorial tax principle, stipulating that only income generated within the country’s borders is subject to income tax. This principle applies regardless of the taxpayer’s nationality or residence. The reform also introduced rules for taxing foreign source passive income – such as dividends, royalties and interest – when derived by multinational entities lacking adequate economic substance. These provisions are consistent with measures adopted by jurisdictions like Uruguay and Hong Kong, which faced similar EU scrutiny.

Resolution No MH-DGT-RES-0030-2023 established objective criteria for determining economic substance within multinational groups. These criteria encompass operational presence, employee functions and financial resources. However, guidance on implementing these rules remains limited. A 2024 private letter ruling highlighted the taxpayer’s responsibility to independently assess compliance, underscoring the need for clearer directives from the tax administration. This lack of clarity has left room for interpretation, which will likely lead to litigation and disputes.

The reform also emphasised the integration of the territoriality principle across Costa Rica’s schedular income tax system, which encompasses distinct regimes for corporate taxation, foreign remittances, individual income and passive income. While Congress intended the clarified territoriality principle to apply uniformly, the tax administration has challenged its application to withholding taxes on foreign remittances. This stance has fuelled uncertainty, prompting expectations of disputes that may escalate to litigation and involve the Supreme Court.

Additionally, the reform represents an opportunity for Costa Rica to strengthen its international tax compliance. By adopting a proactive stance in resolving ambiguities and aligning its tax administration practices with global norms, the country could attract greater foreign direct investment while ensuring equitable tax enforcement.

Pressure for public finance consolidation

Costa Rica faces significant fiscal pressures, driving efforts to consolidate public finances through enhanced tax enforcement. The Ministry of Finance’s 2024 Accountability Report highlights achievements including over 6,600 business inspections, 283 audits and sanctions that resulted in the closure of 114 businesses. Collectively, these actions generated approximately USD55 million in additional revenue.

Despite these advances, challenges persist. Informality remains a major barrier to tax collection, with 45% of employment being outside the formal economy. This dynamic exempts a substantial segment of the workforce from tax obligations, disproportionately shifting enforcement efforts to compliant businesses. Illicit trade and contraband further erode revenue collection, complicating the government’s ability to meet fiscal targets.

The Ministry of Finance has called for legislative action to strengthen the tax administration’s audit and control tools, as well as revenue collection. Proposed measures include adopting a global income system, including worldwide income tax, implementing advanced data analytics for compliance monitoring and introducing stricter penalties for tax evasion. However, these initiatives face resistance due to concerns about their potential impact on compliant taxpayers and the broader economy. Balancing enforcement with incentives to formalise the economy will be critical to achieving sustainable fiscal consolidation.

One area of opportunity lies in addressing the gaps in enforcement against illicit trade and contraband activities. Strengthened border controls, combined with technology-driven customs processes, could reduce revenue loss. Additionally, fostering collaboration with regional trade partners and leveraging international agreements could enhance enforcement efforts. Moreover, increasing transparency in public finance allocation could incentivise greater compliance among taxpayers.

Pillar 2 and its implications for Costa Rica

Costa Rica’s commitment to the OECD’s two-pillar solution, including the global minimum tax (Pillar 2), reflects its dedication to aligning with international tax standards. Pillar 2 introduces a 15% minimum tax on multinational enterprises, posing significant challenges for Costa Rica’s FTZR, which is a cornerstone of the country’s economic development strategy.

The FTZR has played a pivotal role in attracting foreign direct investment, generating employment and fostering economic growth. Companies operating within this regime benefit from incentives such as income tax holidays, VAT exemptions, and waivers on customs duties. These incentives are critical factors influencing multinational corporations’ decisions to invest in Costa Rica.

However, Pillar 2 threatens to undermine these advantages. The Global Anti-Base Erosion (GloBE) rules allow jurisdictions to claim taxes on income generated in Costa Rica if the effective tax rate falls below 15%. To address this challenge, Costa Rica could adopt a qualified domestic minimum top-up tax (QDMTT), enabling the country to collect additional taxes locally. Implementing a QDMTT would require legislative action and careful consideration of its impact on the FTZR’s competitiveness.

Complementary measures are essential to preserve Costa Rica’s attractiveness as an investment destination. These measures could include enhancing non-tax incentives, for example through workforce development programmes, infrastructure improvements and streamlined regulatory processes. Additionally, targeted engagement with stakeholders, including multinational corporations and trade organisations, will be crucial to maintaining confidence in the FTZR.

The role of the United States, Costa Rica’s largest investor, is particularly significant in this context. US policies on Pillar 2 will likely influence Costa Rica’s approach. Strict implementation by the USA could pressure Costa Rica to adopt similar measures, while a more lenient stance could provide flexibility in balancing compliance with competitiveness. Further collaboration between Costa Rica and the USA could also create synergies in the management of the economic implications of Pillar 2.

Conclusion

Costa Rica’s recent tax reforms demonstrate its commitment to fiscal transparency and international standards. However, challenges remain, including ambiguities in the FSIE regime and the potential impact of Pillar 2 on the FTZR. Balancing compliance with global standards against the need to safeguard the country’s economic model requires innovative fiscal strategies and stakeholder collaboration.

To navigate these complexities, Costa Rica must adopt a multifaceted approach. Key priorities include implementing a QDMTT, addressing informality and enhancing enforcement mechanisms while fostering an environment conducive to investment. Strengthening public-private partnerships, particularly in sectors driving economic growth, could further bolster Costa Rica’s resilience in the face of global tax shifts.

By leveraging these opportunities, Costa Rica can position itself as a competitive and transparent jurisdiction, ensuring sustainable growth in an interconnected global economy. Continued dialogue with international organisations and alignment with best practices will also be crucial to securing Costa Rica’s place as a leader in tax policy innovation.