Territoriality of Income Tax in Costa Rica

Picture of Felipe Guevara Leandro

Felipe Guevara Leandro

Over the past thirteen years, Costa Rica has undergone a profound process of tax reforms. During this time, there has been no legislative change to the principle of territoriality, nor has the interpretation of the producing source, as developed by the Tax Administration, been formally adopted. Furthermore, the law does not include references to the “economic structure and producing source.” On the contrary, territoriality has been reinforced, and Art. 6, paragraph ch), of the Income Tax Law remains unchanged.

However, at the judicial level, an extensive interpretation of territoriality was validated, even under a constitutional analysis. This created an atmosphere of legal uncertainty for taxpayers, as it left it to the discretion of the Tax Administration to determine whether income generated abroad was taxable or not.

The absence of regulations to subject extraterritorial income to taxation was so evident that, in February of this year, the European Union included Costa Rica in the list of non-cooperative jurisdictions in fiscal matters, precisely because it allowed the double non-taxation of passive income (by not taking them) from Costa Rican companies abroad.

This prompted several lawmakers to draft Bill No. 23,581, titled “Amendment to Law No. 7092, Law No. 7092 of April 21, 1988, and its amendments, Income Tax Law, to achieve Costa Rica’s exclusion from the European Union’s list of non-cooperative jurisdictions in fiscal matters.”

Following a constitutional process of presidential veto and legislative resealing, the project became Republic Law No. 10,381, which introduces the following reforms:

    • Passive income obtained by Costa Rican companies with no economic substance, commonly referred to as “shell companies,” belonging to a multinational group, will be subject to taxation. This would apply to the income of companies with no economic substance that aim to generate passive income abroad without being subject to taxation in Costa Rica. This is to comply with the European Union Code of Conduct and be excluded from the European Union’s list of non-cooperative countries and territories for tax purposes. In other words, the Income Tax Law already includes a specific exception to territoriality when a company is not considered “qualified” under the terms of the law.
    • Additionally, the Law clarifies and defines the imposition criteria governing our system, including a third paragraph in 1 of the Income Tax Law, stating:

“For the purposes of this Law, income or benefits from Costa Rican sources shall be understood as those generated exclusively within the national territory in accordance with the definition of territorial space, and for these purposes, the national territory shall be understood as defined by the geographical boundaries established in Article 5 and Article 6 of the Political Constitution, derived from services rendered, property located, capital invested, and rights used, obtained during the fiscal period, in accordance with the provisions of this law, regardless of the nationality, domicile, or residence of those involved in the legal business operations, as well as regardless of the origin of the property or capital, the place of negotiation on these, or their connection to the economic structure in the national territory.”

    • This inclusion eliminates the extended interpretation that the Tax Administration has been giving to the territoriality criterion. As a result, the criteria of “economic linkage” and “producing source” lose their validity, and the Tax Administration can only consider as taxable income those generated exclusively within the national territory, with the exception mentioned in point 1.
    • Since this was not an authentic interpretation of 1 of the Income Tax Law, it appears that the reform should not impact previous or the current tax periods.

Undoubtedly, significant progress has been made towards Costa Rica’s exclusion from the European Union’s gray list, but more importantly, legal certainty has been restored for taxpayers.