San José, Costa Rica, since 1956
Doing Business

A fixer upper in tax rules for business might not be the best solution yet

Imagine that mom, looking for a clever way to improve the family’s finances, comes up with a new rule: anybody in the house who wants to eat ice cream has to pay a license to do so. Dad has to pay, your 17-year-old sister Annie (who gulps the stuff like there’s no tomorrow) also has to pay, and you, 6-year-old Timmy who eats it rather occasionally, have to pay as well. You think the cost of this license for Annie, who arguably gets a lot more enjoyment (and gallons) out of it, might be higher. You may also imagine that Dad, a grown up with a paycheck at the end of the month and who could afford a higher fee, would also pay more. But mom says no: everybody pays the same. You are Timmy. How do you feel?

A similar situation happened with Costa Rica’s tax on corporations. Before it was suspended by the Sala IV last year, there was only one flavor: a flat yearly fee of ₡212,000 or roughly $400. It didn’t matter if you were Walmart or the tiny coffee shop on the corner owned by doña Marta, you all had to pay the same. Kind of like Timmy’s situation. While for a big corporation paying $400 per year might be less than the annual budget for sugar packets and paper cups at the coffee station, for doña Marta, trust me, it was a big deal.

Now legislators are trying to bring the tax back in a more palatable form.

In what some believe is an improved version, the latest corporate tax bill includes differentiated fees according to a company’s revenue:

  • For companies with yearly revenue of less than ₡51 million ($96,000): the tax would be ₡106,000 ($200)
  • Between ₡51 million ($96,000) and ₡119 million ($225,000): ₡127,000 ($240)
  • More than ₡119 million ($225,000): ₡212,000 ($400) (the amount originally proposed)

Can you see what they did here, though? Walmart still pays the same $400. But now doña Marta pays half. We are not even going to discuss the difference between payment capacity because that’s evident even to 6-year-old Timmy, but it does make you wonder what the rationale behind this new proposal was. Because in order to give small business a break, the best solution they could come up with was giving doña Marta a discount, effectively reducing total tax revenue compared to the initial version of the law.

However there might be business people that view this new tax as a license, or a right to operate, and since everybody gets the same right, it shouldn’t matter how much money you make with it. Except it does. Taxing is one of the few mechanisms societies and governments have to fight wealth inequality and although it’s seldom used for those purposes, this was a great opportunity at least not to contribute to it. Because let’s be honest: if you are of the many companies whose annual revenue is north of $225,000 you can afford to pay four or five times what doña Marta pays. In perspective, a yearly expense of $800 is not going to make that much of a dent in your profits, will it?

The proposed change to the law does improve on giving new and small businesses a break, but the magnitude of the difference in the fees in regards to income is still disproportionate, and it effectively diminishes tax revenue by leaving big companies with the initial amount. A tier pricing model in which bigger companies could make up for the discount given to small and medium-sized businesses, or SMEs, would have seemed like a more sensible solution, and it’s hard to imagine nobody thought of that.

Now there is a workaround that would enable a small company to avoid paying altogether: If you register your startup or SME with the Ministry of Economy (MEIC). This encourages new companies to join the formal economy and gives them the break they critically need at the first stages. The process, however, is not as hassle-free as you would want it to be, and because it is not widely known, many small companies don’t take advantage of this.

In the end, there’s nothing wrong with mom trying to get a few extra bucks in exchange for ice cream privileges, but if not done correctly, Timmy might either give up eating ice cream altogether, or worse, might sneak to the fridge at night, when mom is not watching.

Read more “Doing Business columns” here

Randall Trejos works as a business developer, helping startups and medium-sized companies grow. He’s the co-director of the Founder Institute in Costa Rica and a strategy consultant at Grupo Impulso. You can follow his blog La Catapulta or contact him through LinkedIn. Stay tuned for the next edition of “Doing Business,” published twice-monthly.

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Ken Morris

This is a persuasive argument on its face, but considered more carefully, it isn’t.

The article implies that the corporate tax is the only tax businesses pay, when this isn’t true. Yes, Doña Maria may have to pay half the corporate tax that Walmart pays, but with that her tax bill ends while Walmart’s climbs much higher.

To use the ice cream analogy, it’s like asking Timmy to pay a flat $5 a month for ice cream privileges while asking Annie to pay $10 plus 10% of the cost of the ice cream she eats that is more than Timmy eats. At the end of the month, this might turn out pretty fair–and hey, it’s worth $5 to Timmy to have access to ice cream.

The article also overlooks the fact that Doña Maria doesn’t have to incorporate in the first place. She can run her business as a sole proprietor, you know. Nobody is twisting her arm to incorporate.

And this brings up the important issue, namely that there are tens of thousands of corporations in Costa Rica that don’t do any business at all, and don’t intend to. Rather, they are established by consumers to hold property–usually houses and cars, sometimes guns, cell phones, and other things–for the primarily purpose of allowing the owner to avoid ordinary legal responsibility.

Example: Timmy grows up and buys a car, and does so in his own name. Annie also owns a car, but through a corporation. Timmy and Annie like to drag race. One day their drag race gets out of control and they both smash into a school, each runs over a child, and each child is crippled for life. Since Timmy bought his car in his own name, he not only loses his crashed car but also has to pay the medical bills for the child he crippled for the rest of the child’s life. Annie however only loses her car, since it was the only assets her corporation had, and doesn’t have to pay the medical bills for the child she crippled.

How much of a tax should Annie have to pay for the privilege of being able to refuse responsibility for a child she crippled?

The answer is of course that no amount of tax makes this legal ruse for avoiding responsibility just, since incorporation by consumers for this purpose is morally wrong.

However, instead of doing the right thing and ending this blatant abuse of incorporation privileges (a move that would also require straightening out the probate mess, since consumer incorporation is also motivated by avoiding it), the lawmakers figure that they might as well make $200 a year off the consumer-abusers.

This is, to say the least, very shortsighted thinking on the part of the lawmakers. However, it’s probably explained by the fact that the lawmakers themselves have drawers full of these consumer corporations and would rather pay the $200 than to lose their privileges.

BTW, this whole situation is a huge drag on the economy. It’s a full employment act for dozens of lawyers and requires scores of public employees to maintain the corporate records–all so Annie can run over a child and avoid financial responsibility for that.

I do feel for Doña Maria, but she’s far from the tip of this nasty iceberg. Plus, she doesn’t have to incorporate in the first place if she doesn’t want to pay the $200. What’s wrong with taking personal responsibility for a business you operate?

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Randall Trejos

Thanks for the comment Ken,

This tax is indeed NOT the only tax business pay, however the article focuses on this one in particular, and especially in the way it was designed. I’m not discussing all taxes and whether or not they are fair, I merely point out that there are much better ways this one in particular could have been setup to maximize revenue while giving SME’s and startups a break.

Doña Marta does not have to incorporate indeed, but there are benefits of operating under the corporation figure, instead of you as a person, and I’m not referring to running over poor kids at school with your car. Given that although not obligated to, there are benefits to incorporate, I’d be nice if we had a different treatment for businesses that are just getting off the ground.

Finally the use of corporation to hide assets, limit personal liability and other shady uses that people could give them, is again a valid point, but outside of the scope of the article. Taxing or not those corporations is not the issue, what people can do with them and how to regulate that might be.

Again thanks for sharing your thoughts.

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dht

Don Randall,

Thank you for your excellent analysis of the issue at hand.

I have a question I am hoping you can help me (us?) with…

Many of us here in Costa Rica were advised by our lawyers to place assets such as land and bank accounts into separate non-active corporations. The intention was to legally protect the assets and their owners from unscrupulous practices and people, plus make it easier to legally transfer assets. This advice was given mostly before the government decided to tax corporations.

These inactive corporations make no profit. They are there as a protective measure only, and would not likely be necessary in a more robust legal system.

My questions are:
1. Does the government plan to tax non-active corporations again – and if so at what amount?
2. How and to whom can we make an effective case to state that taxing a significant yearly amount against these non-active corporations is wrong and unjust?

I can understand a minimum mount – say 5,000 colones yearly so the government can track and confirm these corporations are still in use, but any amount above that is simply a tax grab.

I have kept the numerous articles of blatant government waste of taxpayers dollars over the past several years. The amount is in the high hundreds of millions of dollars – and those are just the major cases that received some public notoriety. It’s time the government looked to it’s own practices and responsibilities rather that take the low road and continue to milk those least able to pay or complain.

Your thoughts?

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Randall Trejos

Hello DHT,

I would not be in a position to give you tax advice, but any attorney or tax accountant can definitely help you . As far as I know there is still no clarity if or when would that tax on non-active corps be reactivated.

Regarding whom to make the case on any unfairness in tax policies, to my knowledge there’s no one stop shop for channeling complaints but you might want to look into Defensoría de los Habitantes for guidance. As in any part of the world, media attention and political lobbying are probably the most effective vehicles to spark the conversation about better ways to approach the tax problem.

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Alan Seaman

People do not leave Cleveland to visit Cleveland Costa Rica style. They come to see a different country. Costa Rica is the third world. I think that is actually a good thing, and that is foolish to pretend that we are something else—or strive to become something else. We have street vendors. It is part of our charm. So why pay untrained/overpaid Government idiots to assault people working diligently to provide an appreciated product so their families can get by on $20/day? Why should every driver in the country pay a Spanish company to inspect their cars, when Government is incapable of building a road truly capable of driving on—with sidewalks for people to walk? If you’re going to talk the talk, walk the walk, but I suggest we’re better off being what we are & proud of it.

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