Selected Issues


Selected Issues

Nicaragua: Coping with Transfer Pricing; the Special Case of Commodities and Free Trade Zones1

A. Introduction

1. One of the distinguishing characteristics of Nicaragua’s tax system is the extensive use of exemptions and incentives to prop up economic activity, especially exports. Export Tax Free Zones (FZ) were introduced in 19912, allowing investors to import inputs exempt from tariff duties and VAT (as most special export zones do), but they also enjoy an exemption on corporate income tax (CIT).3 Exporters outside FZ also benefit from other tax incentives, for example, a CIT credit is available for up to 1.5 percent of the value of exports.4

2. Exports have increased substantially thanks to foreign direct investment (FDI) in manufacturing in FZs. Nicaragua’s economy has globalized quite significantly. Annual trade represents about 95 percent of GDP (2016), while net inflows of FDI have averaged nearly US$ 800 million annually over the past five years5. An important industry has developed in FZs around the assembly of harnesses and apparel destined to international markets, representing a large proportion of Nicaragua’s total exports (Table 1). This activity represents now a significant source of employment.6 However, a growth strategy driven preeminently by tax exempt sectors may crucially dampen the state’s capacity to mobilize revenues for development in the long-run, which may represent eventually a significant policy challenge.

Table 1.

Nicaragua: Exports by Product, 2016

(US$ millions)

article image
Sources: Country authorities and IMF staff calculations

3. Globalization of the economy poses an additional tax policy challenge for Nicaragua. Inevitably, integration into the world economy brings along the complication of taxing multinational corporations. Globalized industries subject to CIT are exposed to tax base erosion and profit shifting (BEPS)7, especially through the manipulation of transfer pricing (TP) of cross-border transactions8. A similar complication may arise with domestic companies that operate with the FZ, as TP can serve to shift profits from the domestic economy into the FZ. The flipside is that profits shifted out of FZ via transfer pricing may seem innocuous, since those profits are not taxed in Nicaragua. However, TP manipulation may result in underestimating tax expenditures associated with the FZ. As explained below, it can be in the interest of transnational enterprises to undervalue exports even if profits are not taxed in Nicaragua.

4. Nicaragua has strengthened somewhat its international taxation framework, especially TP, but this has not become operational yet. TP legislation was adopted in 20129, allowing four years before it became effective, so that taxpayers and tax authorities could prepare for it. However, as the date came due, the task appeared quite daunting for all stakeholders. Its entry into force was postponed till June 30, 2017.10 This new date is now close and whether the administration’s capacity is up to the challenge is still an open question11. But there is also an issue about priorities and simplifying the system, to make TP work where it matters. This section of the report discusses some aspects in the design of a TP regime that deserve special attention in Nicaragua.

B. Transfer Pricing on Commodities

5. Applying the arm’s length principle for related party transactions is the standard to avoid profit shifting through TP. There are various methods, as established by Organization for Economic Cooperation and Development (OECD) guidelines, 12 which can be applied to verify that a transfer price is arm’s length, among them, the most intuitive: comparing the transfer price agreed in the controlled transaction with the price paid in the market (among independent parties) for a comparable good traded in similar circumstances. This is the Comparable Uncontrolled Price (CUP) method. At first sight, this method could be most useful for benchmarking commodity TP, since commodities—relative to other goods—are more homogenous, are traded in very efficient and well organized international markets and have normally a daily, publicly quoted price. However, related parties often price commodity exports following other methods that may easily erode the tax base of the producer country.

Commodity exports are important for Nicaragua

6. The taxation of income from commodity exports is a sensitive issue for developing countries and Nicaragua is no exemption. For many developing economies commodity exports are a very significant proportion of their income tax base; at the same time, they represent the more modern and globalized sector of their economy, where large international businesses operate. Consequently, this tax base is particularly vulnerable to aggressive international tax planning, which can shift income away from producer countries.13

7. Nicaragua’s exports originating outside the FZ are mostly commodities. The top five commodities14 (meat, coffee, gold, sugar and oil seeds) represent around 60 percent of Nicaragua’s total non-FZ export (Table 1). Another US$397 million worth of commodity exports originate in the FZ (2016). The most important activity in the FZ in Nicaragua is a sizeable and labor intensive manufacture, dominated by apparel and auto harnesses (included in electrical equipment), sectors that represent by themselves not far from half of Nicaragua’s total foreign trade. These sectors imply a different tax policy challenge, which is discussed in section D below.

Tax Planning with Commodity Pricing

8. Locating a related intermediary in a low tax jurisdiction, which allegedly provides a trading service, is a common tax planning strategy. The scheme is essentially very simple: the intermediary performs no real functions, but it pays a low price for the commodity and resells it at spot prices to the final customer, keeping the difference, allegedly, as a payment for a marketing (or other similar) service. The goods, of course, are shipped directly to the customer with no intervention by the intermediary, except for issuing the contracts. There are a number of variants to the same scheme, but they all ultimately create a wedge between the international quoted price for the commodity in question and the price paid to the production affiliate. It reduces the tax base in the exporting country, which is kept in the dark as to the final price and customer of the commodity it exports.

9. Another scheme to transfer profits from the producing country is to sign contracts retroactively selecting dates when the spot price was lowest within a certain period. The trade will also be made typically through an intermediary (a related party) in a low tax jurisdiction which contractually resells the commodity at the current spot price. This amounts simply to backdating contracts, which can be done because they are, for all practical purposes, in-house contracts.15

10. Often taxpayers do not refer their commodity exports to internationally quoted prices; they resort instead to a profit-based valuation method. There are primary products that do not have a deep and transparent market and thus a CUP method may not apply. In such cases, other (OECD accepted) TP methods may be more appropriate. Alternative methods normally target the profit rate obtained by independent parties engaged in business activities comparable to that of the taxpayer. 16 But comparable businesses do not mean identical; comparability for TP purposes means sufficiently similar so that differences do not affect the price significantly or can be reasonably adjusted for. There is room for discretion in deciding when comparability is reasonable, which can become a contentious issue; comparability standards employed by taxpayers will tend to be much stricter with CUP than with other methods and it is objectively very difficult for tax authorities to determine when this asymmetry is being stretched too far to switch to a “profit method” (which may give very different results).

Protecting the Tax Base

11. Many developing countries, especially in Latin America, have limited the discretion taxpayers may exercise in pricing controlled commodity transactions. Argentina’s is probably the stricter approach. Exports of primary goods sold to a related party which is a conduit entity, different from the final customer, must be valued according to quoted prices in international markets at the date of shipment.17 The approach is particularly strict because it does not allow for adjustments to the international spot market price (for example, a quote from the London Metal Exchange) to reflect differences with the taxpayer’s actual transaction, such as shipping costs and quality grades. Uruguay has a similar TP regime for commodities but allows adjustments for insurance and shipping costs, and taxpayer’s transactions with independent customers (an internal comparable) are also accepted. 18 Mexico has a different approach: it prioritizes the use of CUP, as defined by OECD (thus, with reasonable adjustments), in all transfer pricing cases.19

12. Nicaragua has no regulation specific to TP on commodities; this is a concern for authorities and should be reviewed. Given the importance of commodities in Nicaragua’s foreign trade and the need for relatively simple TP rules, Nicaragua could benefit from Latin American experience in protecting the commodity tax base. The rest of this section discusses what could be a balanced regulatory approach for Nicaragua.

Most Appropriate Method

13. A key issue is that taxpayers should not cursorily reject the CUP method. Without regulation prioritizing CUP for pricing controlled commodity transactions, taxpayers will typically argue that such method can apply only with the maximum level of accuracy for comparability, accepting spot market benchmarks only for identical commodities20 and thus dismissing CUP routinely in favor of a profit method. The problem is, in a nutshell, that the marginal producer tends to set the international reference price for commodities and this price determines the economic rents obtained by competitors which enjoy production advantages. Since these advantages vary quite substantially from one commodity producer to another (they may change, for example, from one end of a mine to another), trying to impute a profit margin to a commodity producer from averages profits made by ‘similar’ operations, may completely misplace taxation rights on very sizeable economic rents. This error is avoided if TP is determined as a reference to an actual (and relevant) commodity price. Developing countries have moved farther than the OECD in this respect, but with differing approaches. The OECD was noticeably careful when evaluating this issue in its work on BEPS; it only went as far as saying that “… the CUP method would generally be an appropriate transfer pricing method for commodity transactions between associated enterprises…”.21 Nicaragua could justifiably aim at being more ambitious than OECD consensus on this topic, examining cautiously other countries’ experiences (see Box 1).

Nicaragua: Commodity TP Regulations in Developing Countries

Several countries in Latin America have privileged CUP for pricing controlled commodity transactions.1 Argentina’s is probably the stricter approach and the origin of what has been branded as the “Sixth Method” (introduced in 2003). Exports of primary goods sold to a related party that is deemed to be a conduit entity, different from the final customer, must be valued according to quoted prices in international markets at the date of shipment.2 The ‘Sixth method’ does not apply when the intermediary abroad complies with certain conditions that would indicate it is an actual trader and not simply a paper entity. The approach is particularly strict because it does not allow for adjustments to the international market price (for example, a quote from the Chicago Mercantile Exchange) to reflect differences with the taxpayer’s actual transaction, such as shipping costs and quality grades.

There are different approaches, some more flexible. Uruguay also allows only a CUP method for commodities but allows adjustments for insurance and shipping costs; taxpayer’s transactions with independent customers (internal comparables) are also accepted as pricing benchmarks.3 Uruguay also allows taxpayers to register contemporaneously contracts with the tax authorities, so that the date of the contract can be accepted for anchoring the date of the quoted price. Colombia does likewise, and accepts other evidence that date of contract is legitimate.4 Since 2013 the law in Brazil5 only permits CUP for commodities and authorizes the tax authority to determine what will be considered as commodities and which commodity exchange should be recognized for applying that method; the use of publications from authorized institutions in the case of commodities not traded on a stock exchange market are allowed as well. Freight and insurance costs and an average market premium, can be considered when comparing with the benchmark. Also, a “divergence” margin of 3 percent is permitted,6 Mexico has a different approach: it prioritizes the use of CUP, as defined by OECD (thus, with reasonable adjustments), in all transfer pricing cases.7 Ecuador instead recently repealed its ‘Sixth Method’ to adopt the OECD approach, which allows taxpayers to freely determine (and justify) which is the most appropriate method case by case.8

1OECD (2015b), p. 53.2 Ley de Impuesto a las Ganancias, (Argentina), art 15, sixth paragraph (which explains the name for this method).3 Dirección General de Impuestos (Argentina), Decreto 56/009, January 1, 2009. It also allows date of registering contract.4 Estatuto Tributario (Colombia), art 260–3.5 Brazil, Law 12715/12.6 IN1.312/12.7 Ley del Impuesto sobre la Renta (Mexico), art. 180.8 Ecuador, Decreto 973, 19 de abril, 2016

14. Potential problems remain even when a CUP is applied. Although commodities are generally very homogenous products, their actual price may reflect physical and other differences. International standards seek TP to reflect those differences, permitting adjustments to the quoted market price to accommodate the actual transaction carried out by the taxpayer. Arguably, this is a difficult task for a small tax authority such as Nicaragua’s, with very scarce resources. The case could be made for limiting the types of adjustments allowed to the market spot price, for example, adjustments for shipping and insurance costs and quality differences, and possibly aim at setting a small range around the market price to consider for other differences. Allowing no adjustment is evidently too strict and allowing them only for some commodities is somewhat arbitrary, while permitting them only under certain circumstances could be very difficult to manage.

Contract Dates

15. Contracts among related parties can be set to benefit the enterprise and sacrificing the interest of any one of the contracting parties. Further, contracts can be simulated, for example, backdating can shift profits even when applying CUP. Several countries have taken away discretion from taxpayers and regulate the date in which the price is verified for valuing a commodity transaction. There are options: the date of shipment is one unbiased reference; or the average price for several days before or after that date is equally unbiased. Countries like Uruguay allow taxpayers to register contemporaneously contracts with the tax authorities, so that the date of the contract can be accepted for anchoring the date of the quoted price. These are logical anti-abuse measures to protect the integrity of a CUP method which could be adopted in Nicaragua. However, allowing contract dates according to non-defined “industry practices”, as it used to be in Peru,22 undermines the anti-avoidance purpose of the rule. Allowing only the shipping date as a reference might be more restrictive than necessary.

Conduit Traders

16. Applying specific anti-abuse measures only to commodity transactions with (related) shell companies may be too narrow. The “Sixth method” is often applied only when the foreign customer is a related party that operates as a “paper” entity which is not the final destination of the exported commodity. One fundamental problem with this exemption is that it is very hard for the tax authority to verify the taxpayer’s version of the facts, even if the burden of proof is with the taxpayer. This is particularly difficult if paper transactions were carried out through entities that have other real functions. But regardless of simulations, an entity with real business functions, for example, the refiner of mining products, may have reasons to shift profits away from its related mineral producing affiliate (lower tax rate, losses, etc.). This alone would suggest not to target the anti-avoidance rule too narrowly. A simpler, less strict, but more general rule could be more appropriate for Nicaragua.

C. The Additional Problem with Free Zones

17. Some agro-industrial products are exported from FZs, free from CIT. Capital mobility, that is, enterprises that can easily move from one country to another and are therefore in stronger negotiating position, has fostered intense tax competition among nations.23 CIT rates dropped considerably in most countries, while special tax free zones competing for FDI have flourished in Central America and the Caribbean. FZs in Nicaragua are an expression of this international competition to attract foreign businesses. Less mobile capital is thus a more secure source of taxation, for example, income from immovable property, exploitation of natural resources, or enterprises that need to be close to their consumption market. Generally, primary exports are closer to this end of the spectrum. Consequently, CIT exemptions for modern primary exports sectors, which may enjoy considerable economic rents, are harder to justify.

18. Agro-industrial processes may be subject to locational decisions and thus sensitive to international tax competition. Developing countries have traditionally sought to increase the value-added of their commodity exports. Allowing agro-industrial activities to develop in the FZ, in the understanding that they would otherwise continue to locate abroad, would explain this policy. However, this policy introduces additional TP risk for Nicaragua’s tax base, as purchases of primary goods into the FZ could also transfer domestic corporate profits into the Zone through TP abuse. In this way, a routine and relatively simple manufacturing function in the FZ, packaging for example, could concentrate a very high proportion of the total profits generated in the whole value chain controlled by an enterprise operating on both sides of the FZ, de facto extending the tax exemption well beyond the FZ. The potential tax revenue costs in such cases could undercut the benefits of the FZ whenever unprotected from TP manipulation. Although the current tax legislation in Nicaragua requires that transactions with related parties in the FZ be priced at arm’s length, in the absence of more detailed regulations for commodities, it can be easy to plan around them.

19. The problem can be compounded with high value-added agro-industrial activities. Transforming primary products into manufacturing goods may require very specific know-how, which international markets may associate closely with certain jurisdictions; sometimes this can be legally protected as a denomination of origin, or as registered international brands. These intangibles, which may represent significant economic rents for taxpayers, can be registered anywhere and in this regard they represent a very mobile asset. However, when the intangible is driven by a distinct locational reputation (a Mexican tequila, a Cuban cigar, a Colombian coffee) the actual activity cannot migrate without losing its reputational value. Countries often have some type of protection against the tax consequences from the legal migration of brands (or other intangibles), including a deemed capital gains tax upon exit. TP can weigh in by requiring that transfer of the intangible must have the effect (for tax purposes) of a deemed sale valued at arm’s length and thus consistent with royalties paid thereafter. Otherwise, countries with a territorial system, such as Nicaragua, are particularly vulnerable. Migrating a brand abroad, so that it is held by a foreign subsidiary, would generate deductible royalty payments for the Nicaraguan user but the corresponding earnings would be considered foreign source income and remain untaxed.

20. Transfer pricing rules can protect the tax base of companies dealing with the FZ. It is accepted practice that the tested party, i.e. the party that must demonstrate that it operates at arm’s length, be that which carries out the simpler functions in the transaction in question. That could be the case of the affiliate in the FZ if its function is fundamentally that of packaging or reselling a primary product. It would then be rewarded accordingly, probably with a relatively low profit margin, keeping the full residual profit in the head of the domestic commodity producing affiliate.

D. Transfer Pricing and Tax Expenditures in Nicaragua’s Free Zones

21. In an earlier study, tax expenditures (TE) from the CIT exemption in FZ were estimated at 0.24 percent of GDP (2013).24 This is probably underestimated for more than one reason. One of them is that the calculation is based on data filed by the companies established in the FZ, whose income is exempt from tax and thus not audited for its veracity. Moreover, assembly plants of multinational enterprises operating in FZs are set up typically as costs centers, so profits shown in their balance sheets are just enough to fund expansion programs or some backup reserves. Intra-company services are priced to that effect, eliminating the need for an explicit repatriation of profits to whichever affiliate of the group performs treasury functions. So, the actual revenues registered by companies in the FZ, most probably, will not be arm’s length.

22. A more recent study, with a different methodology, estimated TE for FZ at 0.48 percent of GDP (2014)25. The new methodology, rather than relying entirely on the profits declared by entities in the FZ, calculates an effective average CIT for the rest of the Nicaraguan economy and applies it to the gross revenues declared by those entities. The estimation error however is not fully corrected since revenues are also a function of transfer pricing.26 Nonetheless, the result might be closer to the real TE in FZ: assuming an arm’s length return for a typical assembly plant in the American market of 6.5 percent over total cost and expenses,27 as benchmarked by Mexico’s safe harbor28 rule for maquiladoras, the TE for FZs in Nicaragua would be above 0.4 percent of GDP.29

23. The potential magnitude of TE (measured at arm’s length) should be kept in mind when considering renewal of CIT benefits in the FZ. In the longer-run, an option for a smooth transition out of the CIT exemption granted within the FZ should be devised, substituting the current 60 percent reduction in the rate after a (potentially) 20-year tax holiday. Instead, immediately after the initial ten-year term expires, entities in the FZ could transit into a safe harbor determining a minimum taxable profit margin, with which taxpayers would comply with all TP requirements. The full statutory CIT rate should apply to that profit margin. Otherwise, when companies now reach the end of their tax holiday in the FZ, they may pay a reduced CIT rate on very little, unless Nicaragua enforces complicated TP rules. The simplicity and certainty of a TP safe harbor, which will generate positive tax revenues, seems an attractive policy option for Nicaragua FZ.

E. Conclusion

24. Nicaragua might consider developing its TP practice concentrating its efforts on two key areas: commodities and maquiladoras. 30

  • The induction into TP compliance and enforcement could be eased with more comprehensive regulation on commodity trading. Some measures that could be adopted:

    • Identify key commodities that should be subject to special treatment.

    • Prioritize CUP as the most appropriate TP method to value those commodities.

    • Extend this priority to all controlled transactions of such commodities.

    • Define specific (short list) of TP adjustment allowed (e.g., transport, quality, volume, type of contract).

    • Set reference price on shipping date, or average for short period around that date (e.g. one week), and allow registering contract so that contract day can be used also.

    • Revert tested party to foreign or FZ related party to price services they may provide in connection to Nicaraguan commodity exports, especially when relatively simple, routine agro-industrial activities operate in the FZ. Pricing them accordingly will place the residual profit in the domestic value chain.

    • Consider an exit tax on a deemed sale when intangible property is transferred to the FZ or abroad.

    Consider adopting a TP Safe Harbor option, defining a minimum arm’s length profit margin, as an exit strategy for companies benefiting from tax holidays in the FZ. The Safe harbor would apply instead of renewal of tax privileges.


  • BDO (2015), “Argentina, and the so-called “sixth method””, Transfer Pricing News No 16, Feb. 6.

  • CEPAL (2016), La Agenda 2030 para el Desarrollo Sostenible y los Desafíos del Financiamiento para el Desarrollo, Santiago Chile.

  • Cortes Selva, Ana (2014), “Gasto Tributario y Evasión en Nicaragua: 2010–2013”, Ministerio de Hacienda y Crédito Público, Managua, Nicaragua.

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  • Dirección General de Políticas y Estadísticas Fiscales (2016), “Actualización de Gasto Tributario de Nicaragua, 2013–2014”, Ministerio de Hacienda y Crédito Público, Managua, Nicaragua.

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  • IMF (2014), Spillovers in International Corporate Taxation; IMF Policy Paper, May 9.

  • OECD (2010), Transfer Pricing Guidelines for Multinational Corporations and Tax Administrations, OECD Publishing, Paris.

  • OECD (2013a), Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris.

  • OECD (2013b), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris.

  • OECD (2015a), Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 – 2015 Final Report, OECD/G20 Base Erosion and Profit ShiftingProject, OECD Publishing, Paris.

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  • OECD (2015b), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8–10 – 2015 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris.

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  • OECD (2015c), Explanatory Statement, OECD/G20 BEPSProject, OECD Publishing, Paris.


Prepared by Roberto Schatan, with the assistance of Rosalind Mowatt.


FZ were first introduction in 1976, but they were short lived.


User firms of FZ are exempt of CIT for 10 years, renewable for a second term; after they benefit from an exemption of 60 percent. Service and interest payments to foreign residents are also exempt. Ley de Zonas Francas de Exportación, octubre 8, 2015 (art. 20)


Maquila-type exports outside FZ enjoy this benefit as well as VAT and tariff exemptions for temporary imports. This regime is known as “Régimen de Admisión Temporal para Perfeccionamiento Activo”. Ley (No.302) de Admisión Temporal para el Perfeccionamiento Activo y de Facilitación de las Exportaciones, 19 de marzo, 2001.


Source, BCN.


The FZ employed over 110,000 workers in 2016, representing two thirds of total manufacturing employment in Nicaragua; source, BCN.


The OECD discussed in detail the problems in international taxation leading to BEPS. See OECD (2013a); OECD (2013b). Recommendations on how to address BEPS summarized in OECD (2015c).


Revenue losses, while probably significant, can be easily exaggerated. One source of confusion is with what some authors call ‘illicit flows’, which is the difference resulting from contrasting export data from one country with the import data from the destination country (and vice versa). That difference could be explained in more than one way, some due to illicit trade, but not due to TP manipulation, which is not carried out by differences in the invoices presented in exporting and importing countries. See for example, El Nuevo Diario, Precios de trasferencia dejaran US$300 millones, Nicaragua, noviembre 20, 2015, citing CEPAL (2016) p. 135.


Ley de Concertación Tributaria (LCT), diciembre 17, 2012. (Ley No. 822). Arts. 93–106.


Ley No.922, December 17, 2015.


¿Listos para los precios de transferencia?, La Prensa, Nicaragua, diciembre 19, 2016.


OECD discussion on BEPS specifically addresses the issue of commodity pricing, which is discussed below. See OECD (2015b)


Commodities understood as primary goods which have a daily international price benchmark.


Manipulation could also occur with strike prices in controlled future contracts.


See OECD TP Guidelines (2010), op cit. Profits rates (either gross or operational profits) can be measured in various ways for this purpose.


Introduced in 2003, it pioneered this type of regulation, often called the ‘Sixth method’. Ley de Impuesto a las Ganancias, art 15, sixth paragraph (which explains the name for this method). The ‘Sixth Method’ does not apply when the intermediary abroad complies with certain conditions that would indicate it is an actual trader and not simply a paper entity; further discussed below.


Dirección General Impositiva (Uruguay), Decreto 56/009, enero 1, 2009. It also allows date when contract is registered with authorities.


Ley del Impuesto sobre la Renta (Mexico), art. 180.


OECD (2015b), p. 53.


Ley del Impuesto a la Renta (Perú), art. 32-A, e). Modified by Decreto Legislativo 1312, December 31, 2016.


The TE includes both the net alternative minimum tax (1 percent on turnover) and the CIT forgone above that minimum. Cortes Selva (2014).


At the same time, assuming that the industry in the FZ should have a profit margin similar to the average in Nicaragua’s domestic economy, including banking and other sectors which may enjoy some economic rents, might lead to an overestimation of the TE.


Ley del Impuesto sobre la Renta (Mexico), art. 182, II.


A Safe Harbor for transfer pricing purposes is a rule whereby the authority establishes publicly a minimum profit margin above which a specific industry, under defined circumstances, would comply with the arm’s length principle.


Total cost and expenses is obtained from subtracting profits from total exports; profits are equal to the CIT TE for FZ registered in Cortes Selva (2014) divided by the CIT rate.


Limitations to interest payments deductions is another area interest for TP in Nicaragua, but not discussed in this paper. See OECD (2015a).