Economic Substance Impact on Tax, Accounting in Panama

Ivelisse Bonilla Castillo, Tax Director at ARIAS Panama and tax specialist, presents the following article: Economic Substance and Its Impact on Taxation, Accounting, and Risk Management

Economic substance has become increasingly relevant across the financial, tax, and compliance spheres, among others, where its analysis is conducted with progressively greater rigor. It is closely linked to the accounting and tax principle of business reasonableness, which is also recognized under frameworks such as the International Financial Reporting Standards (IFRS) and U.S. GAAP.

Its origins trace back to the 1935 decision of the United States Supreme Court in Gregory v. Helvering, which addressed a corporate restructuring designed to obtain tax benefits without genuine economic support. Since that precedent, the economic substance doctrine has been firmly established in common law jurisprudence and now constitutes a central element of international tax analysis. Organizations such as the Organization for Economic Co-operation and Development (OECD) have further developed this concept through studies and recommendations that guide tax authorities in assessing structures and transactions with tax implications.

Before examining its evolution, it is necessary to define economic substance. Broadly, its purpose is to align the financial reality of a transaction with its formal characteristics, ensuring consistency while preventing legal formalities from distorting the proper presentation of financial information. This distinction is particularly relevant in cases where legal form does not accurately reflect economic substance, especially in complex transactions or sophisticated contractual arrangements.

In practice, the inability to demonstrate economic substance in an entity that purports to conduct ongoing business activities entails significant risks. These include the potential denial of bank account openings, as economic substance is closely linked to due diligence and know-your-customer (KYC) processes. It may also result in the freezing of funds, since the receipt of income without a clear economic justification can trigger anti-money laundering alerts. From a tax perspective, insufficient evidence may enable tax authorities to unilaterally recharacterize the entity’s tax position, potentially leading to complex audits and the imposition of penalties.

This approach has been reinforced at the international level by the OECD through initiatives such as the BEPS Project, which promotes standards to ensure that profits are taxed where value is effectively created, thereby strengthening the requirement for economic substance in corporate structures and cross-border transactions. In this context, concepts such as functions, assets, and risks (FAR) analysis, beneficial ownership, and anti-abuse provisions have assumed a central role in tax assessments.

Panama has not been immune to this trend. In 2016, Panama joined the BEPS Inclusive Framework (Base Erosion and Profit Shifting), committing to measures aimed at preventing base erosion and profit shifting—strategies used by multinational enterprises to exploit gaps in tax rules and artificially allocate profits to low- or no-tax jurisdictions. Through this commitment, Panama undertook to adopt rules and instruments to combat tax evasion, ensuring that profits are taxed where the underlying economic activities are performed and where value is created.

In particular, BEPS Action 5 focuses on combating harmful tax practices, emphasizing transparency and substance. It establishes that tax benefits should only be granted where they are fully aligned with the real economic activity that generates them. In essence, economic substance constitutes the underlying premise for the application of preferential tax regimes.

Since then, special regimes such as the Multinational Headquarters Regime (SEM), the Panama Pacifico Special Economic Area, and the Colon Free Zone have been amended to condition tax benefits on compliance with substance requirements, including qualified personnel, real operating expenses, and core activities carried out within the country.

While these regimes differ in their commercial focus, they share common elements1 that are subject to scrutiny by their respective authorities when assessing whether a company qualifies for tax benefits; such elements derive from the international tax framework.

1. Performance of economic activities or group-support functions
2. Qualified full-time personnel
3. Adequate facilities and operating expenses commensurate with the nature and scale of operations