By: David Erales.
In the last 10 years there has been a difference of criteria between taxpayers and the Superintendence of Tax Administration as to whether the capitalization of profits of a corporation is regulated as an income tax generating event and, consequently, whether or not such tax must be paid.
The capitalization of profits is the commercial act by means of which the shareholders of a corporation agree not to distribute the profits generated during a certain period (usually annual) with the intention, among others, of leaving such resources at the disposal of the corporation either for its use in the normal operation of the company, for investment or for the purchase of goods (assets). In the capitalization, the company’s paid-in capital is increased, which is why the company delivers new shares to the shareholders free of charge, which represent the increase in the company’s equity.
On the other hand, the distribution of dividends is the mercantile act in which the shareholders of a corporation agree to distribute the profits generated in a certain period, receiving in payment money or a good (in kind) from the corporation.
Art 83 of the Tax Update Law establishes that the generation, in Guatemala, of capital income and capital gains and losses, in cash or in kind, which come, among others, from rights whose ownership corresponds to the taxpayer resident or not in the country, is considered as an income tax generating event. These include those derived from the ownership of shares in corporations.
Art 84, paragraph 2, literal d), indicates that taxable income is classified, among others, as income from movable capital, among which is the distribution of dividends, profits, and earnings, regardless of the denomination or accounting given to it.
The Tax Administration has equated the capitalization of profits with the payment of dividends in kind in accordance with art 83 and 84, paragraph 2, subsection d), of the Tax Update Law, and has held that, when the tax generating event is configured as an income from movable capital, the tax is caused.
The argument of the Superintendency of Tax Administration is summarized in that, derived from the capitalization of profits, the shareholder receives new shares, which, in accordance with the law, are considered movable property. Therefore, it considers that a dividend payment was made, only that it was not materialized in money but through the delivery of an asset (shares), by means of which the shareholder’s equity is increased.
The taxpayers, on the other hand, have established their position that they should not withhold the tax because the capitalization of profits is not the same as the payment of dividends in kind and, consequently, since there is no payment of profits or dividends in favor of the shareholder, this commercial act cannot be included in any income tax generating event.
Taxpayers have argued, among others, that such mercantile operations are not comparable, since in the capitalization of profits:
- The shareholder does not receive any payment.
- The profits belong to the corporation, and when the capitalization is agreed, they remain in the corporation. The shareholder is deprived of his right to receive the dividends to economically strengthen the equity position of the corporation.
- The company delivers the new shares (free of charge) because of the capitalization (increase of the paid-in capital stock) in accordance with Art 208 of the Code of Commerce.
- There is no outflow of assets by the company to the shareholder, neither in cash nor in assets (goods).
- Pursuant to Art 111 of the Code of Commerce, a corporation is prohibited from disposing of the shares of the corporation itself; therefore, the corporation cannot legally pay dividends with shares of the same corporation.
In the first cases, the Contentious Administrative Courts, the Supreme Court of Justice, and the Civil Chamber had agreed with the taxpayers in the sense of indicating that the capitalization of profits is not a payment of dividends in kind and, consequently, that the obligation to pay or withhold the tax does not arise.
However, the Constitutional Court agreed with the tax authorities and, upon hearing the disputes, ruled that: “in order to decide on the capitalization of profits it is necessary that the latter were at the disposal of the shareholders, which configures the generating event and entails the tax burden, considering that the condition to dispose of something is that it has been delivered to them. From the foregoing, it follows that although the capitalization of profits is lawful, prior to its realization, the tax burden must be applied, or the payment in kind must be taxed if it has already been made”.
However, the Constitutional Court agreed with the tax authorities and, upon hearing the disputes, ruled that: “in order to decide on the capitalization of profits it is necessary that the latter were at the disposal of the shareholders, which configures the generating event and entails a tax burden, considering that the condition to dispose of something is that it has been delivered to them. From the foregoing, it follows that although the capitalization of profits is lawful, prior to its realization, the tax burden must be applied, or the payment in kind must be taxed if it has already been made”.
The Constitutional Court has recently given a jurisprudential twist changing this criterion and establishing that now the capitalization of profits does not constitute payment of dividends in kind. In short, it considers, among others.
- That through the capitalization of profits there is no change in the percentages of participation of the company. In the case of the capitalization of profits, by increasing proportionally for all shareholders the number of shares or their value, it results that the corporation does not undergo any change in its shareholding structure and therefore, no shareholder increases its percentage of participation.
- In the capitalization of earnings there is no change in the real value of the shares. In the book value of a company, the shareholding of any shareholder is worth or reflects an equal value before and after the capitalization, therefore, what is configured is a rearrangement or updating of accounting accounts. However, the book value of the shareholder’s participation does not undergo any change as a result of the referred operation, therefore, there is no effective increase in equity that is susceptible to be taxed by the Income Tax, being precisely the generating fact the receipt of an income.
- There is no immediate enjoyment of the effect of the capitalization of profits: the spirit of the tax legislation (Income Tax) is to tax those capital gains that the shareholder will receive because of the payment of the profits, thus contributing with a part of such profit to the common and social good defined by the State. However, in the case of the capitalization of profits, the shareholder does not immediately receive or enjoy the result of this corporate operation, since those profits -now converted into capital- correspond to the equity with which the company must respond to third parties for its operations. That is to say, the capitalization is not an act executed in favor of the shareholder (as would be the payment of its profits to its bank account, for example) but rather, it is an act that strengthens the equity of the company and of those who contract with that entity, reason for which it is not possible to observe the existence of an element that allows the taxation of equity on an act of strengthening of the company in question and not of the shareholder;
- The benefit or capital gain that the shareholder will receive is uncertain. It will be until the liquidation of the company in which it will be determined, if it is the case, if the shareholder effectively receives a greater patrimony than the one he contributed to the company; therefore, if it is less, there will be no profit to be taxed and, if on the contrary it is greater, at that moment he must pay the corresponding tax derived from the profit as established by law, at which time, the increase in his patrimony can already be measured since it will be a certain and determined amount, which can be taxed in accordance with the provisions of the Tax Law;
- By trying to equate the capitalization of profits with a payment of dividends, there is a violation of the principle of legality in tax matters, by virtue of the fact that, according to the provisions of Art 83 of the Tax Update Law, the increase of capital by issuing new shares, through the capitalization of profits, does not constitute a generating fact of Income Tax, making, in the present case, an interpretation by analogy, which is a violation of the principle contained in Art 239 of the Constitution.
The Constitutional Court, by means of the jurisprudential change, has correctly established that the effects and scope of a capitalization of profits are not the same as a payment of dividends in kind and, therefore, it is not subject to payment or withholding of Income Tax. This change of criteria is expected to last over time and to be respected by the Superintendence of Tax Administration, especially by the Contentious Administrative Courts, the Supreme Court of Justice and the Civil Chamber.
The foregoing will provide taxpayers with the necessary legal certainty and security, which translates into peace of mind so that they know their rights and obligations, and allows them to make informed decisions as to what to expect from the State when capitalizing profits, in the sense that they will not be required to pay (to the shareholder) or withhold (to the company) income tax since, as the Court itself has recognized, it is not a tax generating event.