The VAT Trap: Why Is Chile’s VAT System So Poorly Setup?

Chile’s VAT system doesn’t make sense. Once you are in the system, the reporting system is world class and has been ranked in the top five in the world for ease of use. The Chilean IRS’ website works incredibly well, is fast, reliable and makes paying your taxes a breeze. It blows the US system out of the water and it’s not even close.

But getting legally approved by Servicio Impuesto Interno (the Chilean IRS) is a bureaucratic, capricious, time consuming process that doesn’t make any sense. After the long and complicated process to incorporate and get a bank account (that I’ve talked about before), you need to get your boletas (receipts) and facturas (official invoices) so that you can legally sell and pay your taxes.

The boleta process is straightforward and allows you to sell to individuals or companies that don’t want a tax refund. But if you want to sell to a business, you need to have a factura (official invoice) or nobody will buy from you and your business will fail. And that’s where the problems start.

Facturas are government issued documents that break out the VAT tax so that the buyer can get a VAT credit and get to keep the money if they’ve sold items subject to VAT. For example, if a business sells something for US$10.000 + VAT with a factura, they’ll have to pay US$1.900 of VAT. At the end of the month, they’ll have to go online and pay the government US$1.900 on the top notch SII website. But if they buy something for US$10.000 with a factura, they get a credit in their favor for US$1.596, which lowers their VAT liability.

It would seem that getting a factura should be simple, but its not. If you intend to sell product, in an ecommerce store for example, you need to go to the IRS with paperwork showing that you’ve purchased product that you will later sell. You need to take that purchase facturas to the IRS, wait in line, and ask for your factura. So if you want to start a business and sell legally, you need to take money out of your pocket and purchase product that you can’t legally sell. This makes small business owners dig into their startup capital just to be able to legally sell.

In my ecommerce business, I went to the IRS with my factura that showed that I purchased US$200 or product, waited in line for 30 minutes. When I finally got to present my factura, the bureaucrat laughed in my face. He told that one factura and US$200 of purchases wasn’t enough. I asked what the rule was: how many facturas and for how much money. The bureaucrat told me he couldn’t tell me, that there wasn’t a bright line rule, but that he knew that if he presented my factura it would be declined and that I wouldn’t be able to sell legally.

I came back a week later with another factura, this time for US$1000, in addition to my US$200. The same thing happened. I got fed up and hired an accountant to do the dirty work. It took the accountant three trips to the IRS to finally get it approved. She was sent home one time because the notarized copy of my company’s tax ID wasn’t sufficient, even though the plastic card vs. a notarized version are exactly the same in the eyes of the law. It took four months before I was finally able to start to sell legally. My $1200 was tied up the entire time and I couldn’t legally operate my business.

Entrepreneurs with less startup capital would have started to sell illegally, depriving the government of tax revenue and making the entrepreneur into a tax evader.

The whole process doesn’t make any sense. First, why does the government care if you’ve purchased goods to sell in order to have a factura? It’s ridiculous. Why put another barrier to successfully starting a business and paying the government tax revenue? A barrier that makes entrepreneurs have months of extra startup capital or incentivizes them to skirt (or break) the law?

What’s the worst that could happen? If an entrepreneur submits a factura for a sale that never happened, the entrepreneur would be paying 19% VAT tax at the end of the month. So the downside of making it easier for businesses to get started and sell legally is that the government will collect extra 19% VAT taxes?

Second, if the government insists on forcing entrepreneurs into purchasing goods before they can legally get the documents they need to sell them and pay their taxes, why doesn’t the government have a bright line rule? You must have four purchase orders that total at least $1000 and you’ll be approved? Why let capricious bureaucrats decide and make entrepreneurs lives that much more difficult? It just doesn’t make sense.

Now that you have your facturas, the government puts up another, bigger, barrier for small business owners. When you sell with a factura, you must pay your 19% VAT on the 12th of the next month. For example, if I sell US$10.000 + VAT in August, on September 12th, I must pay the government US$1.900. That wouldn’t be a problem if companies paid immediately, but in Chile companies pay net 60 and many times net 90 or even 120. And that’s if they pay on time at all! That means that I have to take $1.900 out of my pocket to pay my taxes and effectively finance the government and large businesses while I wait to get paid.

One of my portfolio companies in Magma just sold US$12.000 + VAT net 180. Without doing net 180, they wouldn’t have closed the sale. That means my portfolio company needs to pay $2.280 in VAT on August 12th and have the funds necessary to finance the government and their large client for six months!

Since most companies don’t pay for 60-120 days, a new business will pay 19% taxes on their sales two to five months before they even get a single cent in revenue. VAT taxes are the biggest barrier to actually starting a business and making it successful. The government and big businesses have teamed up to thwart new entrants to the market.

In Europe and the rest of the OECD, the vast majority of countries allow small businesses to pay their VAT taxes quarterly or even annually, which means that companies have at least 90 days to collect their sales so that they don’t need to pay their VAT out of pocket. Colombia, South America’s fastest growing economy, is Latin America’s only country that doesn’t charge monthly, thereby helping more companies start successfully.

Since VAT policy is an administrative issue, the government could make changes immediately to help small businesses. So why don’t they? If Chile moved to a quarterly regime for companies selling less than US$400.000 annually like Italy, the government would take a short term cash flow hit, but after four months, the government’s net revenue would be the same. And the government would have instantly helped thousands of entrepreneurs and existing small businesses survive.

Chile has spent money on Startup Chile, on creating an online business incorporation system, but it still hasn’t done the most basic of all fixes: allowing small business and new entrepreneurs to pay quarterly or biannually. I only see three three possibilities:

1. The government doesn’t trust small entrepreneurs to be able to plan for four bigger payments per year
2. The government and the elites in government don’t know this is a problem that kills entrepreneurship
3. The rules were put in place by the elite to help thwart new entrants to the market

I always ask Chilean entrepreneurs which of the three reasons they think is the real reason. About 25% think its because they think the government doesn’t trust entrepreneurs to manage their finances, half thinks that the government is incompetent and the last 25% think its to thwart new entrants into the market.

My personal opinion is that it’s a mix of all three. The government must know it’s a problem, but probably doesn’t really understand how much of a problem it is. Most people in government are elites who have never run a business before. And those that have are mostly in the upper class and likely had enough money to survive the VAT trap.

Chile is like a country club, with massive classism (which is really just racism), that’s mostly controlled by the top 10%, so it wouldn’t surprise me if the VAT trap was put in place to thwart new entrants to the market.

ASECH, Chile’s entrepreneurs lobbying group, has been pushing for the buyer to have to pay the VAT tax on a monthly basis (Spanish). This change would work, as large companies would have to pay when they buy from small businesses, but its a much more radical and intrusive change for businesses. If you simply allow small businesses and entrepreneurs to report their VAT quarterly or semi annually, you solve the problem for the vast majority of businesses.

I’m not optimistic about the changes that Chile will change the VAT payments requirements from monthly to quarterly in the near future. I think the government doesn’t really trust its citizens, politicians with no knowledge of what it takes to run a business don’t really understand how big a problem the VAT trap is, and elites in power are either ignorant to the problem or like the barrier against new competition.

What do you think?