On 27 May Panama approved a law on economic substance rules for foreign-source passive income received by multinationals. This tax code reform requires them to show a real economic presence in Panama to maintain the favorable tax treatment of this income. Multinationals that fail to meet the criteria will have their net taxable passive foreign source income (e.g. dividens, royalties, interest) taxed at 15%.
The reform is designed to prevent tax avoidance through structures that have no operations or direct economic activity in the country.
Economic Substance Requirements
To maintain favorable tax treatment for their foreign-source passive income and be considered a “qualified entity”, multinationals (including the ones falling under preferential regimes), must demonstrate having the following within Panama:
- Qualified & adequately compensated personnel
- Appropriate physical facilities for carrying out activities
- Strategic decision-making within the country
- Operating costs & expenses linked to income generation
Partial exceptions to point 3 & 4 are foreseen for entities whose principal activity is the holding of equity interests (e.g., holding companies) in other local and/or foreign entities and the acquiring and or holding of real estate.
A “Non-Qualified Entity” is understood as any entity that forms part of a multinational group, is incorporated or domiciled in the Republic of Panama, receives any of the foreign-source passive income and falls within any of the circumstances mentioned in the law.
The law maintains Panama’s current territorial tax system, under which only income generated within Panama is subject to tax. However, non-qualified entities that fail to comply with the applicable requirements will no longer benefit from the territorial tax regime in relation to their foreign-source passive income and will be subject to a 15% Income Tax (ISR) on net taxable income for the relevant fiscal period.
Passive income from foreign sources subject to the economic substance requirements are:
- Dividends or profit shares,
- Interest,
- Royalties
- Capital gains
- Income from Real Estate Capital
- Other income from movible capital
Covered Entities: Multinational Groups
The Law applies to entities belonging to “multinational groups,” defined as a group of two or more entities, linked by ownership or control, that are tax residents in different jurisdictions, including their parent company, subsidiaries, and permanent establishments.
Excluded Sectors
The Maritime Sector (Merchant Marine) and Financial Sector entities (Regulated Entities, e.g. banks, insurance & reinsurance entities, security market intermediaries, investment funds, pension funds) are excluded from the law.
Reporting obligations
The entities covered by this law must report annually in their Annual Income Tax Return the passive income from foreign sources received and the information necessary to demonstrate compliance with the economic substance requirements.
Entities Subject to Preferential Tax Regimes
Entities belonging to a multinational group that operate under a special tax regime, such as the SEM Regime, Colón Free Zone or Panama Pacifico, and are subject to economic substance requirements must include specific disclosures in their annual Income Tax Return. This obligation also applies to entities under these regimes that are not required to prove economic substance but earn foreign-source passive income. To be treated as qualified entities, they must report their foreign-source passive income and provide the information needed to evidence adequate economic substance for each category of such income received.
Outsourcing
The principal activities referred to above may be outsourced to third parties, provided that such activities are carried out within the territory of the Republic of Panama. In addition, the resources used by the service provider to evidence the adequate economic substance of an entity must not involve overlapping hours when those same resources are used to provide services to several recipients.
Outsourcing principal activities outside the Republic of Panama will not, by itself, constitute a failure to comply with the economic substance requirements. In practical terms, outsourcing principal activities abroad will not cause the entity to be classified as a “non-qualified entity”; nevertheless, any resources used outside Panama will not be considered when evaluating the entity’s economic substance within the Republic of Panama.
Entry into force & European Union Review
This Law will come into effect starting 1 January 2027.
With this initiative Panama aims to be removed of the European Union’s list of non-cooperative jurisdictions for tax purposes. The Council of the European Union is expected to carry out its next review of the list of non-cooperative jurisdictions for tax purposes in October.