Is income taxation in Brazil fair and equitable? For some years now, there has been an intensified discussion of this issue in the country.
The debate began by questioning the exemption of dividends, which has been in force since 1996. As a result of this exemption, it has been observed that a significant portion of individuals’ income is not taxed, generating a feeling of injustice, especially when comparing this exemption to the burden on labor income.
Other exemptions provided for in this legislation, especially those that benefit the wealthiest section of the population, have also come under discussion, such as the deferrals granted to exclusive closed funds and to the profits of offshore companies.
In this scenario, in 2021 the Federal Government presented Bill 2.337, which brought with it the taxation of dividends, accompanied by a reduction in the rates of taxation of corporate profits, the inclusion of taxation of exclusive funds in the “come-cotas” system, and several other specific changes to the legislation, such as the extinction of interest on equity.
The bill suffered a lot of criticism, both because it had been drawn up by the Federal Revenue Service, with an excessively revenue-raising bias, and because it was felt that the issues dealt with were little discussed with civil society, since it was sought to be fast-tracked through Congress, with no room for further debate and improvement. In the end, after the presentation of several substitutes with changes on the bill and a few unsuccessful attempts at approval, it was decided not to go ahead with it, and the issue was not addressed until the government elected in 2022 took office in January of this year.
Since the presidential campaign, the reform of income taxation was presented by the ticket that would be elected as an important issue, both to help reduce the fiscal crisis the country is experiencing and to promote greater social justice and equality.
The new administration began with a strong emphasis on reforming taxes on consumption, which culminated in the House approving PEC 45/2019. However, from the outset, the urgent need for an income tax reform was also on the agenda.
The main items on this agenda, in the government’s view, would be the immediate taxation (without the current deferral) of profits earned by offshore companies and of income from exclusive closed-end funds. The taxation of dividends appeared in the debate as necessary, but as something that still needed to be analyzed more thoroughly and in-depth, especially after the failed attempt to tax it through Bill 2.337/21.
In this context, Provisional Measure 1,171/2023 was published in May 2023, as the first stage of the income tax reform. This measure, in addition to updating the IRPF table, proposed changes to the taxation of income applied abroad by residents in Brazil. After a few months of discussion, however, the measure was not converted into law on time, and an agreement was reached for its provisions to be resubmitted in the form of a Bill of Law, which was presented by the Executive to Parliament on 29.08 last, under number 4.173/2023.
Following what had already been proposed by the Provisional Measure, Bill 4.173/23 establishes an “anti-differential” rule for income earned by individuals through Private Investment Companies (“PIC”), known as “offshores”. Its aim is to equalize the taxation of income earned directly abroad by individuals, with that levied on income earned through the incorporation of offshores.
This is because, according to the rules currently in force, when a Brazilian individual makes financial investments directly abroad, their income is taxed in Brazil as soon as it is earned, with the taxpayer paying the tax monthly, allowing the tax paid abroad to be offset.
However, if the same individual sets up an offshore company, and this entity becomes the owner of the investments, the profits made abroad are not taxed immediately in Brazil, but only when they are distributed to the controlling individual in the country. This is called “deferral” of taxation on offshore profits. As pointed out by the Federal Government in the Explanatory Memorandum of Bill 4.173/2023, “the tax deferral on the taxation of profits of controlled entities abroad can extend throughout the life of the individual, or even after their death, creating a situation of serious tax injustice and acting as a mechanism for income concentration, by exempting high-income taxpayers, who are the holders of investments abroad.”
According to the proposed rules, profits made by offshore companies as of January 1, 2024 will be taxed at the same rates as those applicable to individuals at the end of each year, regardless of their actual distribution to individuals. It should be noted, however, that in order for the offshore company to be subject to this “automatic” taxation of profits, it must meet at least one of two criteria: (i) be incorporated in a favored tax jurisdiction (“tax haven”), or have a privileged tax regime, or (ii) have an active income of less than 60% (sixty percent) of the total income, according to the definitions of active and total income included in the bill.
As a novelty in relation to the Provisional Measure, and in response to the criticisms made during the debates, the Bill, in its article 8, introduced the option for the individual to treat the offshore as “transparent” for tax purposes. Once this option has been made, the individual will declare and tax the assets and rights held by the PIC as if they were held directly by them. This “transparency” option seeks to prevent any gains from offshore companies, resulting from the
market valuation of assets, from being taxed before they are realized.
The bill also changed the form of taxation and the rates applicable to income from financial investments earned by individuals abroad (which will be the same applicable to offshore companies). The tax is no longer payable monthly, but only on the Annual Adjustment Statement, and the rates are now 0% for income of up to R$ 6,000, 15% for income between R$ 6,000.01 and R$ 50,000 and 22.5% for income above R$ 50,001.
A positive novelty in the bill compared to the Provisional Measure was the permission to offset losses and gains incurred abroad in the financial investments of individuals. This rule can also be used by offshore companies that opt for the “transparency” regime and is yet another measure that provides neutrality.
Among the changes for individuals, the bill proposes the repeal, as of January 1, 2024, of the rules exempting exchange rate variations obtained on non-interest-bearing deposits and those calculated on assets acquired abroad with income originally earned in foreign currency. It also proposes the abolition of the exemption for capital gains obtained on the sale of foreign currency in kind and those obtained on the sale of assets abroad acquired as a non-resident.
Finally, the bill maintained the MP’s proposal to deal, for the first time, with an issue that had not yet been regulated by Brazilian tax legislation and remains unregulated by civil law: trusts. The choice made by the rule was to consider the trust, for tax purposes, as a “transparent” company. Thus, the assets transferred by the settlor to the trustee continue to be considered as if they were owned by the settlor, and taxable by him. They must therefore be declared in their DIPF, as well as the income and gains derived from these assets. The trust’s assets and rights, according to the MP, will only pass to the beneficiaries when the settlor dies or when there is an effective distribution of the funds.
In order to cushion the impact of the new rules, the bill provided for the possibility of individuals updating the value of assets held abroad, including trusts, already declared in their Annual Adjustment Statement, until December 31, 2022, with taxation of the difference at a rate of 10%.
Unlike the proposal presented in 2021, the issues dealt with in Provisional Measure 1.171 and now in Bill 4.173/2023 have been the subject of in-depth debate between the Federal Government, civil society, and the Parliament, which has already allowed for the inclusion of various improvements between the wordings of the two documents.
The fact is that a consensus has been reached in Brazil today that it is necessary to reform some of the loopholes in income tax legislation to make the system fairer and more isonomic. Therefore, we believe that this is an inexorable movement, so that if the changes commented on are not approved in Bill 4.173, they will certainly come back later, in other bills.
In the same vein as seeking to correct inequities in income taxation, on the date that Bill 4.173/2023 was sent, the Executive Branch also issued Provisional Measure No. 1.184/2023, changing the rules for taxing investment funds, with the aim of applying the same taxation applicable to open-end funds, to income from closed-end investment funds, in order to promote equality between them. This is the third attempt to tax closed-end funds, which have been dubbed the funds of the “super rich”, following failed proposals by the two previous governments.
Other issues, such as the taxation of dividends, should also be addressed soon, either because of the sense of injustice generated in society by the exemption, or because of the need to tax these and other exempt incomes as a way of bolstering the federal government’s cash flow in times of fiscal crisis.
Julia de Menezes Nogueira is a consultant at Pacheco Neto Sanden Teisseire Advogados.