US embassy cable - 05ASUNCION1242

UNCLAS SECTION 01 OF 03 ASUNCION 001242 
 
SIPDIS 
 
STATE FOR WHA/BSC, WHA/EPSC, EB/TPP/IPE 
STATE PASS TO USTR FOR LYANG, MSULLIVAN 
USAID FOR AA/LAC ADOLFO FRANCO 
TREASURY FOR OSIA MAUREEN WAFER 
COMMERCE ITA SARAH COOK 
NSC FOR MIKE DEMPSEY AND SUE CRONIN 
SOUTHCOM FOR POLAD 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, ETRD, KIPR, KCRM, KMCA, KTFN, PREL, PA 
SUBJECT: PARAGUAY'S PLAN TO FORMALIZE CDE 
 
REF: ASUNCION 423 
 
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SUMMARY 
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1.  The GOP has announced a new tax plan designed to help 
formalize the economy of Ciudad del Este, situated on the 
border with Brazil.  The system will be voluntary and is 
expected to take effect in November.  Participants will 
receive benefits such as lower tariffs and lower up-front 
tax payments upon importation.  In return, participants must 
commit to claiming the full value of imported merchandise, 
sharing financial information to allow for verification that 
purchase prices match declared values, and the collection of 
customer data.  The GOP expects to increase revenues with 
the plan, while minimizing opportunities for corruption. 
Pitfalls abound: Customs is unsure how to implement the 
decree, and businesses are concerned about the potential for 
harassment from prosecutors for past practices.  USAID- 
funded Paraguay Vende played an important role in the 
development of the plan.  The initiative is another example 
of the political will to push forward with economic reforms. 
End Summary. 
 
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A STEP TOWARD FORMALIZING CDE 
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2.  On September 15, Minister Bergen invited the Ambassador 
to a private briefing on the GOP's plan to create tax and 
other incentives to formalize the economy in Ciudad del 
Este, Paraguay's second largest city located in the tri- 
border area.  The Director of the Tax Administration, 
Andreas Neufeld, and Vice Minister of Economy Jorge von 
Horoch also attended the briefing, as did Econchief. 
Minister Bergen briefed the Brazilian Ambassador separately 
the same morning, with the rationale that Brazil is the 
largest market for information technology products sold in 
CDE, and the United States is the largest provider of those 
products.  After three months of low profile work, largely 
based on a study as well as the promotion of dialogue by 
USAID-funded Paraguay Vende, Neufeld announced the 
initiative to the public on September 19, with an expected 
implementation date of November 1. 
 
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CREATING THE RIGHT INCENTIVES 
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3.  The initiative has two basic principles: firms will have 
to sign up and commit to certain actions that will 
facilitate enforcement in order to qualify for the benefits 
of lower taxes, and the new rates and rules should minimize 
incentives to cheat or pay bribes.  It was designed with two 
constraints in mind: the GOP must collect at least the same 
amount under the new regime (Paraguay depends heavily on 
customs revenues), and it must be entirely consistent with 
Paraguay's obligations under Mercosur. 
 
4.  The program, which is supposed to take effect in 
November, will technically apply to all items covered under 
Paraguay's Tourism Regime, which includes information 
technology and telecommunications equipment (IT), 
electronics, perfumes and other luxury items.  Initially, 
however, the GOP anticipates heavy IT participation 
eventually leading others to join.  The GOP will take 
advantage of a special Mercosur preference that allows 
Paraguay to charge a zero tariff on IT products through the 
end of 2005, after which the tariff will return to the 
current level of two percent. 
 
5.  The plan includes a few fundamental changes.  First, 
most tourism regime goods have hitherto been exempt from the 
value added tax (VAT), which runs ten percent on most goods. 
Beginning with implementation of the new tax regime, though, 
all sales of these items throughout Paraguay, to Paraguayan 
citizens, will be subject to the ten percent VAT.  Sales to 
foreigners will be exempt.  Importers who sign up for the 
new regime will only be charged an advance of 1.5 percent of 
the 10 percent VAT, with the balance (on sales to 
Paraguayans) to be collected later.  In practice, though, 
most sales are to foreigners, and importer sales to 
distributors would not trigger the VAT, meaning that the 1.5 
percent will be the final VAT for most importers.  Importers 
who choose not to sign on will be charged the entire ten 
percent up front upon importation of the merchandize, thus 
providing an incentive for importers to register. 
 
6.  Second, advance collection of income tax by customs will 
be reduced for participants from three percent to 0.3 
percent, with the balance collected later.  Vice Minister 
Neufeld considered this change to be fundamental.  The 
ability to offset future income tax liability creates a 
strong incentive for businesses to justify their expenses: 
by demanding legal receipts from suppliers, registering 
workers, etc.  The current system collects all taxes in 
advance, leaving little or no incentive to operate legally. 
In comments to the press after the September 19 
announcement, Neufeld said he expected tax revenues to 
increase, both through a higher volume of merchandize and 
through the increased VAT collections. 
 
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BREAKING THE CYCLE OF CORRUPTION 
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7.  Neufeld provided a side-by-side comparison of the taxes 
paid by a firm undervaluing a shipment by 50% but paying 
taxes under the current system, and the taxes paid by a firm 
declaring the full value of a shipment under the new system. 
The tax paid under the new system for a $1,000 importation 
would be $18.25 versus $26.00 under the current system, even 
with undervaluation.  The $26.00, though, does not include 
the additional costs of bribes to facilitate the 
undervaluation in the first place.  Neufeld also pointed out 
that minimizing taxes collected upon importation also 
minimizes the potential savings to be had by paying a bribe 
to avoid those taxes. 
 
8.  To guard against fraud in the new system, participants 
must agree to report all financial payments and explicitly 
link those payments to particular imports.  The goal is to 
verify declared values of imports by checking that outgoing 
financial transfers match the declared values.  If transfers 
exceed declared values, one would suspect undervaluation. 
The GOP intends to police the new arrangement by relying on 
the cross-referencing of taxpayer customs, tax and financial 
data, with the vetted tax crime investigative unit being 
developed with help from Treasury's Office of Technical 
Assistance (OTA) having primary responsibility. 
 
9.  The plan was developed in close consultation with 
municipal authorities and the portion of the local private 
sector in CDE that wants to formalize (i.e., pay taxes and 
compete honestly and legally).  USAID-funded Paraguay Vende 
played an important intermediary role that included the 
publication of a study on real business practices in the IT 
sector on the border which provided a neutral assessment as 
a basis for designing the initiative.  Bergen explained that 
while they know the plan is not a panacea, they see it as an 
important first step toward the formalization of CDE's 
economy.  He said he fully expects to be attacked, perhaps 
indirectly and in the press, by those interests that will be 
negatively affected. 
 
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BERGEN REQUESTS HELP - TTU FITS THE BILL 
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10.  Since the US is the primary source country for IT 
products imported into Paraguay, Bergen asked the Ambassador 
for help with either providing specific valuation 
information for particular shipments (to cross-reference 
with the declared values upon entry into Paraguay), or with 
independent reference values.  Bergen was concerned that if 
the GOP itself devised a list of reference values, it would 
be accused of being arbitrary, whereas if values came from 
the U.S. or elsewhere, it would be more transparent and 
defensible.  Post's Resident Enforcement Advisor is looking 
into the request. 
 
11.  The Ambassador explained that the Department of 
Homeland Security is working with Paraguayan Customs to 
establish a vetted Trade Transparency Unit (reftel) that 
would be able to share container-level valuation information 
as reported upon export from the US.  Neufeld said such data 
would be a great help, even if a few months behind real 
time. 
 
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POTENTIAL PITFALLS ABOUND 
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12.  Several pitfalls await implementation of the 
initiative.  Sacrificing inclusiveness for secrecy, Tax 
Administrator Neufeld did not include Customs in the 
planning process.  In a September 27 meeting, the Customs 
Director told USAID that Customs was unsure how to implement 
the initiative, and lamented that Customs had not been 
brought into the planning process earlier. 
 
13.  USAID-funded Paraguay Vende worked with the IT Chamber 
of Commerce for several months studying how to design the 
regime specifically for that sector so that it could be both 
formal and competitive.  At the last minute, the GOP decided 
to issue a general decree applying to all tourism regime 
items, instead of starting with the IT as originally 
expected.  Paraguay Vende personnel worry that the lack of 
analysis of the competitiveness of other sectors could lead 
to implementation problems. 
 
14.  Finally, both members of the IT sector and Paraguayan 
Customs are concerned about their vulnerability to 
harassment from prosecutors since the Presidential decree 
that was signed does not provide immunity for participants 
for past business practices.  In theory, prosecutors could 
develop legal cases against participants who suddenly change 
the valuation of their products (i.e., declare the full 
value), after years of under-valuation.  Neufeld told the 
DCM that he had briefed the new Attorney General, who agrees 
that they will not/not prosecute those who come clean.  He 
said he understood the desire of some to have formal 
guarantees against prosecution, but said that would set a 
bad precedent and undermine the rule of law.  Companies 
legitimately formalizing would not face problems, he added, 
but there would be no amnesty. 
 
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COMMENT 
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15.  The plan could work, and is another demonstration of 
the political will of Minister Bergen and his team to 
formalize Paraguay's economy.  President Duarte spoke for an 
hour at the announcement ceremony about the importance of 
formalizing and modernizing the economy.  The planned TTU 
fits in perfectly with the new initiative, which, if 
successful, would make it easier to identify and counter the 
criminal elements operating in CDE involved in piracy, money 
laundering and terrorism finance.  Time will tell if the 
significant pitfalls that await implementation are enough to 
derail the initiative. 
 
KEANE