Brief comments on the upcoming Brazilian Tax Reform

2021 Jul.20

On this short paper, we focus on the main features of the impending Brazilian Tax Reform that directly affect inbound investment. Our comments do not cover any particular investing jurisdiction, but may refer to the expected outcomes of the reform based on the international tax practice.

 

Brazilian Tax Policy Background – the removal of withholding taxes upon dividend distributions and the creation of the Interest on Net Equity

Following the establishment of the Real (BRL) currency in Brazil in 1994 as a result of the Real Plan (“Plano Real”), a successful stabilization plan against the inflationary spiral Brazil had found itself since the mid-80s, a bill of law was issued aiming at adjusting the national tax system to the new economic reality.

Among the main features of such piece of legislation issued in 1995 (Law 9,249/1995) was a Corporate Income Tax rate cut from 25% to 15%, with a 10% additional tax rate for amounts exceeding BRL240,000, granting a certain level of progressivity to the system. Additionally, in order to equalize the tax treatment among the various capital income categories and to balance the debt-bias, the bill also allowed the deduction of interest accrued on shareholders’ equity, the Interest on Net Equity (INE).

Finally, this 1995 bill of law supported a full integration system between the shareholder and invested company, taxing all profits at the level of the company at 34% (15% + 10% for Corporate Income Tax and 9% for Social Contribution on Net Profit) and exempting any profit distributions/dividend payments from withholding tax.

Aiming at aligning the Brazilian tax system to the revamped worldwide international tax scenario (i.e. OECD BEPS Project) and simplifying it, the Ministry of Economy, supported by studies performed by the Brazilian Internal Revenue Service, put forward a bill of law for the reform on June, 2021, reassessing the features mentioned above, as we describe below.  

 

The Reform Bill – a long road ahead?

 

The original bill of law was presented by the Ministry of Economy to Congress mid-June 2021 and presented certain features e.g. the disallowance of Interest on Net Equity payments deduction, a timid Corporate Income tax rate cut and withholding tax upon dividend distributions. Given the backlash the bill promptly created in the market, a substitutive bill was put forward aiming at easing the approval process within both houses of Congress. Below, we demonstrate the differences between the two texts side-by-side for didactic purposes:

 

       
       
   

Original Reform Bill

Substitutive Bill

 

Profit Distributions and Dividend Payments

(a) Profit distributions/Dividend payments as of 2022 are subject to a 20% withholding tax rate (not applied if profits are capitalized);
 
(b) The rate is increased to 30% if the beneficiary is located in a tax haven or is subject to a privileged tax regime (black and gray-listed jurisdictions/regimes, respectively).

(a) Profit distributions/Dividend payments as of 2022 are subject to a 20% withholding tax rate (not applied if profits are capitalized);
 
(b) The rate is increased to 30% if the beneficiary is located in a tax havens or is subject to a privileged tax regime and in the case of deemed distribution of profits (disguised distribution of profits);

(c) Withholding tax exemption for distributions (controlled entities or under common corporate control).

 

Interest on Net Equity

Not deductible for Corporate Income Tax purposes.

Not deductible for Corporate Income Tax purposes.

 

Corporate Income Tax Rate

Base rate from 15% to 12.5% in 2022 and 10% in 2023 (+9% Social Contribution on Net Profit kept).

Base rate from 15% to 5% in 2022 and 2.5% in 2023 (+9% Social Contribution on Net Profit kept).

 

Corporate Reorganizations

(a) No goodwill usage for tax purposes upon business acquisitions in Brazil;

(b) Set linear amortization schedules for intangible assets;

(c) Capital reductions are mandatorily performed at fair market value.

(a) [REMOVED]

(b) Set linear amortization schedules for intangible assets;

(c) Capital reductions are mandatorily performed at fair market value, except for a Brazilian controlling company or under the same corporate control.

 

Offshore Indirect Transfers

Brazilian capital gain taxation upon indirect transfer of assets located in Brazil

[REMOVED]

 

Given the potential changes to the domestic tax system, we present below the implications of the current tax scenario and the anticipated changes to the way multinational groups invest into Brazil.

 

Current landscape and expected impacts of the Reform on inbound investments

Under current rules, Brazilian legal entities are subject to a 34% Corporate Income Tax rate. Such investment remunerates its foreign shareholders via withholding tax-free dividends and Interest on Net Equity subject to a 15% withholding tax but deductible at the full tax rate in Brazil (34%).

Given the most common structures to hold investments into Brazil (via European holding companies e.g. Luxembourg, Netherlands, Spain etc) would characterize such interest in the Brazilian subsidiary as a qualifying participation (assuming a non-portfolio investment) under ordinary participation exemption regimes (under which dividends received from the qualifying investment are exempt), dividends paid to such holding entity would not be subject to tax in the corresponding jurisdiction.

The tax treatment applicable to Interest on Net Equity would depend on the income characterization by the receiving country. If treated as dividends (as it is equity-based), the income flow would be exempt under the same abovementioned participation exemption rules. Conversely, if treated as interest (as it generates a tax deduction in Brazil), the income would be included in the tax base of the receiving entity but a foreign tax credit for the 15% withholding tax would be allowed (certain tax treaties signed by Brazil have also tax sparing clauses that could increase such foreign tax credit to 20% or even 25%, possibly neutralizing the effect for Corporate Income Tax purposes at the level of the holding company).

In the proposed new scenario, assuming the tax burden included in the substitutive bill, legal entities in Brazil will be taxed at 24% (for 2022) and 21.5% (for 2023 onwards).

However, upon dividend distributions, a 20% withholding tax would apply. Such rate could be reduced to 15%/10% if there is double tax treaty in place between Brazil and the country of residence of the beneficiary. For investors located in a tax haven or subject to a privileged tax regime, the withholding tax rate would be increased to 30%. Some examples here would be Ireland (black-listed from a Brazilian perspective), Dutch/Austrian holding companies with no relevant economic substance, and Swiss companies subject to a total tax burden under 20% (gray-listed in Brazil).

Interest on Net Equity would be subject to a 15% withholding tax rate, nevertheless, it would not be deductible for Corporate Income Tax purposes.

Under this new scenario, assuming the income flow would be exempt under the holding company participation exemption regime, the withholding tax at source in Brazil would be a cost for the investor as it would not be creditable at the level of the receiving entity. As Interest on Net Equity payments would be no longer deductible from a Brazilian tax standpoint, they will likely be treated as dividends under the tax rules of the holding company jurisdiction and the 15% would also represent an unrecoverable cost for the investor.

Given the exemption of dividends income at the level of the holding company, potential tax sparing clauses in double tax treaties signed with Brazil would not mitigate the overall tax burden.

Potential scenarios to face this new reality could be:

 

 

Investment structures into Brazil through legal entities that are black or gray-listed from a Brazilian tax perspective would also need to be reviewed as they would bear a 30% withholding tax rate at source with no or limited taxation at the level of the receiving entity; and/or

 

 

As the bill of law will still go through both houses of the Brazilian Congress, additional changes are expected, including discussions on progressive tax rates for dividend distributions, which are already on the table.

 

Finally, we recommend multinational groups investing in Brazil to keep a close look to tax reform developments aiming at planning ahead for potential adverse tax consequences.

Related attorneys: Luis Felipe de Campos /