One of the motivations of the last Tax Reform -Law 1819 of 2016- was to modernize the Colombian tax system with the objective of making it simpler, progressive and more equitable.
With the legislation previous to the tax reform, a Colombian fiscal resident, at first glance, had to determine to which of the categories of taxpayers established by Section 329 of the Colombian Tax Code Section (employee, self-employed person, or another kind of taxpayer) did he or she belong to. This, in order to assess the amount payable for Income and Complementary Taxes.
Depending on the applicable category under Section 329 of the Colombian Tax Code, individuals individuals with fiscal residency in Colombia would assess Income and Complementary Taxes, by applying the ordinary system, the National Minimum Alternate Tax Assessment (IMAN, in Spanish) or the Simple Minimum Alternate Tax Assessment(IMAS, in Spanish).
Also, under the former tax legislation an individual taxpayer was entitled to deduct most of the the costs and expenses, that were incurred in the production of income.
Although the principle of causation was befitting with the income generating activity, costs and expenses that exceeded the corresponding income, could still be indistinctively allocated to other activities that produced income during the same fiscal period.
Under Law 1819 of 2016, however, costs and expenses may only be allocated to the respective category (bracket) of income. This results in a dramatical increase in the tax basis, taking into account the limitations to the expenses and deductions and to the exemptions and the impossibility to deduct payments that are not allocated directly to the realized income.
II. THE TAX REFORM.
As explained above, in the explanatory statements to Law 1819 of 2016, it was argued that the modification to the tax system regarding Income and Complementary Taxes for individuals, aimed to generate a more progressive tax system, under the premise that those who received more income should be subject to a higher effective tax rate.
Nonetheless, because of the modifications introduced to the Bill, the mentioned premise did not fully materialize. Now taxpayers that receive all their income from an employment relation are subject to regulations on the assessment of the taxable basis exemptions and other benefits that applied in the previous legislation.
The tax reform introduces a Bracket Income System (Sistema de Rentas Cedulares, in Spanish) similar to the one that applies in the United States of America, which determines the procedure to assess the income tax base in accordance to each type of income, with the purpose of securing that the allocations of benefitsregarding non-taxable, excluded, and exempt earnings, of costs and expenses and of other benefits that reduce the tax basis, are only applied to the brackets of income with which the exemption, the cost or the expense, have a causal relationship with, and then only, in the percentage that is established by the new Law..
Law 1819 of 2016 also restricts the compensation of tax losses, which only proceeds against income of the same bracket, in subsequent fiscal periods and within the established legal limits and percentages.
III. SCHEDULAR SYSTEM APPLYING TO INCOME TAX ON INDIVIDUALS.
The Bracket Income System categorizes earnings by brackets in accordance with the type of income that is perceived in an specific taxable period.
The tax reform includes the following categories of brackets:
- Income from a labor relationship (Rentas de Trabajo, in Spanish);
- Capital Gains;
- Income not related to a labor relationship (Rentas no Laborales, in Spanish);
- Dividends and participations
IV. INCOME FROM A LABOR RELATIONSHIP
The bracket that holds income from a labor relationship is integrated by earnings by individuals qualifying as individuals salary, commissions, social benefits, travel expenses, representation costs, fees, emoluments to ecclesiastical dignitaries, compensations received for cooperative work, and in general, as any income originated by the rendering of personal services.
The following table summarizes the methodology to assess the income tax basis for earnings perceived from a labor relationship under Law 1819 de 2016:
|Assessment of the Taxable Basis for income perceived from a labor relationship:|
|Gross Income from a labor relationship|
|Net Income from a labor relationship|
|Exempt income and deductions (Up to 40% of labor earnings or 5.040 Tax Value Units – (Unidades de Valor Tributario UVT in Spanish- each equaling COP 31.859)|
For the purpose of determining the taxable income of the bracket "Income from a Labor Relationship", Non-Taxable Income imputable to labor income should be excluded in the first place.
Under Law 1819 of 2016, the following earnings are treated as Non-Taxable: i) financial support for studies, ii) voluntary contributions of members to the Regime of Personal Savings with Solidarity, iii) mandatory contributions to the General Pensions System made by the employee, iv) mandatory contributions to Health Care by the employee, and v), payments to third parties for alimony within the legal limit established by Section 387-1 of the Tax Code.
From the remaining balance, the taxpayer may subtract the exempt income originated in a labor relationship and deductions that do not exceed 40% of the earnings or 5.040 Tax Value Units (UVT, in Spanish) equaling approximately USD $53.523 at an average exchange rate of USD 1= COP$ 3.000) .
The allowed exemptions consist basically in the fringe benefit component of 25%, in voluntary contributions to Pension Funds and Saving Accounts for the Promotion of Housing Construction (Cuentas de Ahorro y Fomento a la Construcción, AFC, in Spanish), interest rates on loans to purchase housing, payments to prepaid medicine and deductions for dependents.
Contributions to Saving Accounts for the Incentive ofHousing Construction (AFC) and voluntary contributions to Pension Funds
Contributions to AFC, are exempt, as long as the relevant savings are destined to the acquisition of housing that is either paid in full or through a mortgage loan or a housing leasing, or in as long as the savings remain in the account for a minimum term of ten years. In the event of withdrawal of the savings before ten years, these funds will be subject to Income Tax and to income tax withholding of 7%. If this is the case, no deduction may be applied to the portion of the savings that have been withdrawn.
On the other hand, voluntary contributions to Pension Funds are exempt, as long as they remain in the fund for a minimum period of ten years or if withdrawn before the expiration of the term, are destined for the acquisition of housing.
In any case, the savings will be exempt as long as they don´t exceed 30% of the earnings from a labor relationship or 3.800 Tax Value Units (UVT, in Spanish) equivalent to around USD $40.535 at an average exchange rate of USD 1= COP 3.000.
Comparison of the previous rules on assessment of taxable income from a labor relationship with the tax amendments introduced by Law 1819 of 2017.
During 2016 and prior years, taxpayers were allowed to reduce income from a labor relationship to cero, in some cases, even applying benefits, costs and expenses in excess of the labor earnings and to reduce the surplus from other types of income, for example income received from a pension or fees paid by third parties, with the same expenses or benefits. This happened even though the law enshrines the Principle of Proportionality and requires that the costs and deductions have a direct relationship with the production of the income, as the relevant exemptions where excluded from other kinds of earnings.
In view of the above, the limitation to exemptions and deductions to 40% of the earnings deriving from a labor relationship resulted in a significant increment to the effective tax rate on income from a labor relationship.
As an example, in the following table you can find a comparison of the tax treatment of a monthly wage of around COP$ 5.000.000 (around USD $1.666) under the previous legislation and the new legislation that came into force as of the first of July of 2017.
|Assessment of Net Income||Previous Legislation (COP)||Law 1819 of 2016 (COP)|
|(-)||Non-Taxable Income||0||$5.760.000 (Contributions to the social security system)|
|(-)||Exempt Income and Deductions||
$5.670.000 (Contributions to the social security system)
$ 10.080.000 (Voluntary Contributions to Pension Funds)
$13.248.000 (Voluntary Contributions to Pension Funds)
$6.048.000 (approximately 1.8% in contributions to AFC)
|Marginal tax rate||0%||19%|
As shown in the previous Chart, the new legislation imposes restrictions to the deductions and benefits which increase the taxable basis and trigger taxes that were only applicable to higher brackets of income .
This is just an example of what has turned out to be a more onerous tax system for individuals who not necessarily represent the beneficiaries of the higher amounts of earnings in Colombia.
V. INCOME DERIVED FROM PENSIONS
This bracket holds the income received from pensions for retirement, disability, old-age, survivorship, and occupational risks. This bracket also includes income from payments of substitutive indemnities for pensions or reimbursements of balances of pension savings.
In this instance, no general restriction was established by the new Law, so the taxpayers may exclude non- taxable earnings and exemptions from the taxable basis, within the specific limitations allowed in each case. However, under the new legislation, taxpayers may not reduce the pensions in this bracket with exemptions applying to other types of earnings.
It is important to keep in mind that monthly pensions are taxed only in the portion that exceeds 1.000 Tax Value Units (the part that exceeds an estimate of USD $10.620).
The Commission of Experts who drafted the Tax Bill recommended an important restriction to the exemptions for pensions, but these restrictions were removed from the Tax Bill by the Colombian Congress.
VI. INCOME TAX RATES ON EARNINGS FROM LABOR RELATIONSHIPSAND PENSIONS
Taxable income from labor and pension earnings is subject to the same rates . Under the new Law , the taxable net income resulting from the assessment of each bracket, is subject to marginal rates that were not altered by the Tax Reform:
|Range in COP (Colombian Pesos)||Marginal Tariff|
VII. CAPITAL GAINS
Any income derived from interests, financial yields, leases, royalties and intellectual property rights qualifies as Capital Gains. To assess taxable income, the few exemptions attributable to this bracket are applicable with no amendments.
Exemptions and exclusions applying to this bracket are the following:
- Inflationary component in financial yield; and
- Mandatory Social Security contributions to pensions and health funds.
Costs and expenses related to the production of capital earnings are also deductible if they are applicable and properly supported by the taxpayer, in other words, if the disbursements are compliant with Colombian law. Accordingly, it is important to bear in mind that general legal requisites such as causality, proportionality and necessity regarding deductions are still applicable, in accordance with market practices.
Section 339 of the Colombian Tax Code was modified by Law 1819 of 2016 in the following terms:
"(...) ART. 339 Net Income in the Capital Gains Bracket.
With the purpose of determining the net income from this bracket, exemptions and costs and expenses dully supported by the taxpayer, are deductible.
All exemptions and applicable deductions to this bracket may be subtracted as long as they don't exceed ten percent (10%) of the basis resulting from the previous paragraph, and provided these do not exceed one thousand (1000) UVT.
Paragraph: The deduction of costs and expenses is allowed provided that these comply with the general requisites established in this Tax Code and that these are applicable to this bracket. (...)"
The regulation above is not clear and could even be -contradictory: The first segment confirms the possibility to deduct all expenses that are applicable and dully supported (expenses that are compliant with the general legal requisites established in the Colombia Tax Code and that are attributable to this bracket). On the other hand, the second segment limits the applicable deductions to 10% of the net income.
Considering that Section 339 of the Colombian Tax Code is self-contradicting as it determines that "expenses attributable to this bracket" are deductible with no restriction whatsoever, but deductions are limited to 10%, we would have to conclude that deductions not representing costs and expenses, but which are attributable to this bracket, would be subject to the 10% restriction.
However, questions arise as to which deductions are applicable to the Capital gains Bracket, as Colombian law only refers to Section 26 of the Colombian Tax Code on assessment of taxable income. In accordance with the mentioned rule, all expenses are deductible from income with no other condition than a cause relationship.
The Colombian Tax Administration (Dirección de Impuestos y Aduanas Nacionales -DIAN-), by means of Concept 5984 of May 13th, 2017, clarified that the deductions subject to the 10% restriction should include exemptions and the following deductions :
"Voluntary contributions to pension funds, savings accounts for the incentive of housing construction (AFC Accounts), deductions for the payment of interest generated by the purchase of housing, 50% of the Bank Debit Tax(Gravamen a los Movimientos Financieros, GMF in Spanish), Property Tax and Industry and Commerce Tax".
We do not share the Colombian Tax Administration's opinion for the following reasons:
- The mentioned benefits have all been categorized as exemptions from labor income, independently of whether the contributor is an employee or an independent worker. These exemptions are allowed up to 40% of the corresponding earnings. It is not clear how, these benefits can be related to capital gains under the current system.
- Concerning Property Tax and Industry and Commerce Tax and 50% of the Tax on Financial Movements (GMF), it is very difficult to maintain that the latter do not qualify as expenses under the first segment of Section 339 and on the contrary, are restricted to a 10% deduction as other tax benefits that do not represent expenses with a cause relationship with the production of income.
VIII. NON-LABOR INCOME
All income that does not fall into the above categories and does not qualify as dividends or distributions, is included in this bracket. Moreover, also included in this bracket are fees obtained by individuals that provide services and have hired or contracted, for at least 90 days, in a continuous or discontinuous manner, two (2) or more employees or subcontractors to provide such services.
All income that is not mentioned in any of the other categories, such as the sale of fixed assets held for less than two years is also included.
In the assessment of such income, exempted gross income is subtracted and the costs and expenses that are dully accounted for by the tax payer. However, just as capital gains income, exempted income and applicable deductions are restricted by 10% of the net income or 1000 UVT (COP$ 31.859.000 for 2017), without no legal distinction between the concepts of applicable expenses and deductions.
Non-labor income is subject to the same tariffs as capital gains income.
IX. APPLICABLE TARIFFS FOR CAPITAL GAINS AND NON-LABOR INCOME:
Capital gains and non-labor income are subject to the same tariffs. For this reason, taxable income resulting from the purge of every bracket must be applied with the following marginal tariffs:
|Range in Pesos||Marginal Tariff|
X. DIVIDENDS AND PROFIT SHARES
Law 1819 of 2016 introduced the taxation of dividends distributed to individuals, notwithstanding that the dividends correspond to profits that have already paid taxes at the entity that distributes the dividends.
Prior to Law 1819 of 2016, dividend payments to shareholders or partners, resident individuals or national entities, were excluded from tax provided that the latter came from profits that had already payed taxes on a corporate level. However, with the entry into force of Law 1819 of 2016, individuals who are shareholders or partners of entities, co-proprietors, associates, or subscribers, among others, are subject to income tax regarding all distributions payed by legal entities.
This bracket is divided into two sub-brackets:
- Profits that have been taxed at a corporate level will be levied at a 0%, 5% or 10% rate depending on the amount of the distribution , and
- Profits that not been taxed at the corporate level are subject to a 35% rate on the gross value of the distribution, and once such percentage has been deducted, the remaining amount will be taxed at rates ranging from 5% to 10%.
For better comprehension, we have included the following Chart regarding the applicable rates on dividends and distributions:
|Dividends derived from profits that have been taxed at a corporate level||Dividends derived from profits that have not been taxed at a corporate level||Dividends payed by foreign entities|
|Range||Tariff||Effective tax rate ranging from 35% to 41.5%||Effective tax rate ranging from 35% to 41.5%|
|0 – 19 Million||0%|
|19 -31 Million||5%|
In accordance with Section 246-1 of the Colombian Tax Code, the aforementioned regulations only apply to dividends derived from profits earned as of 2017.
In other words, dividends derived from profits earned before the year 2017, that have been taxed at a corporate level, will be treated as non-taxable income. Moreover, distributions belonging to profits earned before 2017, that have not been taxed at a corporate level, will be taxed independently of the dividends bracket at the applicable rate for 2016.
The abovementioned, in regards with the applicable transition regime which excludes profits generated before 2017 from the new dispositions on dividend taxation.
XI. APPLICABLE INCOME TAX RATES FOR INDIVIDUALS AND SUCCESIONS WITHOUT FISCAL RESIDENCE IN COLOMBIA.
As a last comment, individuals and successions without fiscal residence in Colombia, will be subject to income tax at a rate that was increased from 33% to 35%.
The Tax Reform increased the applicable income tax rate for individuals without fiscal residence in Colombia to the highest applicable progressive rate for resident individuals in the country.
Furthermore, dividends paid to individuals without fiscal residency in Colombia will be subject to a 5% rate independent of the amount. Similarly, for individuals without fiscal residence in Colombia, dividends that have not been taxed on a corporate level, will be taxed at a 35% rate of the gross value of the distribution. The net balance of the distribution will be subject to the mentioned 5% rate.
With the amendments we have explained the tax system for individuals in Colombia has been substituted with one that is substantially more onerous. Exempt income and certain deductions, specifically non-labor and capital gains income, that used to be applicable without any restrictions, have been restricted to 10% without modifying any of the provisions granting the benefits.
Consequently, many of the fiscal incentives to payments such as insurance indemnities, were reduced from 100% to 10% exclusively for individuals.
Income tax for employees was increased dramatically without any consideration for principles such as progressive taxation or social equality.
The recently introduced changes to the system must be complemented with an effort of the Colombia fiscal authorities to audit and tax millions of Colombian individuals that operate in informality. The latter, in order to avoid that the taxpayers that comply with their obligations in good faith, end up being the only ones contributing to our system.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.