In the past few years, Brazil’s economy has disappointed. It grew by 2.2% a year, on average, a slower rate than other countries like China or India. It contracted by 1.6% in the first quarter, compared to the same period last year, and is expected to shrink by as much as 2% in 2015. Moreover, we have seen an erratic political decision making process that makes it extremely difficult for any foreign investor to evaluate and position himself on the Brazilian market.
Hence, because of this, we have seen multinational enterprises (MNEs) using this period to deal with funding structure established previously with their Brazilian subsidiaries. Funding their operation through debt (instead of equity) holds some well-known advantages such as: possible remuneration through interests and not dependent on the subsidiary’s turning profit, easiness to set up and so forth.
However, in our experience, most Brazilian subsidiaries could find space for tax optimization in this area.
Firstly, sometimes these loans fail to meet Brazilian Thin Capitalization rules. According to such rules, there is a maximum ratio between funding through debt and equity. Failure to meet such ratios would make the payment of interests to be disallowed for Brazilian Corporate Income Tax (CIT) purposes. Moreover, the interests determined between the Brazilian subsidiary and its European MNE cannot surpass 6-month LIBOR plus 3.5%.
Also, most subsidiaries apply the cash-based method for assessing CIT on their loans. The Brazilian legislation allows for the taxpayer to choose at the beginning of the fiscal year between the cash-based or accrual based method, thus, if the taxpayer predicts a fall in the exchange rate throughout the year, by choosing the accrual method it could use the financial expenses generated to offset revenue received on that year.
However, sometimes, because of financial difficulties faced by the Brazilian subsidiary or other operational reasons, an MNE may opt to waive the debts of the Brazilian subsidiary.
According to Brazilian legislation, debt waiver is considered new revenue and is taxed by CIT and PIS/COFINS. It should be mentioned that any waiver would be easily detected by the federal tax authorities and in case of non-compliance by the Brazilian subsidiary could trigger fines and yearly interests.
In order to avoid this taxation, Brazilian subsidiaries have been engaging in converting these outstanding loans into equity.
Such converting triggers no taxation and still allows for the Brazilian subsidiary’s operational flexibility. Especially because increasing the Brazilian subsidiary’s capital not only should help those subsidiaries engaged in public bids but also allows for the MNE to shift more remuneration through Interests over Equity (JCP) and pay lower taxes on the distribution of results to the MNE.
Lastly, it should be mentioned that in order to avoid the delay usually involved in capital reduction in Brazil (with the prior waiting period for potential creditors’ manifestation), Brazilian subsidiaries, incorporated as corporations (S.A.) could withdraw their shares and return the capital faster to the MNE investor.
In conclusion, if at first glance using loans as a vehicle to invest in a Brazilian subsidiary may seem like the best option, it may create difficulties and trigger unforeseen taxation. By using equity instead of debt as well as planning for future contingencies it is possible for the Brazilian subsidiary and its investing MNE to have a more transparent and tax friendly relation without the loss of operational flexibility.
This article has been published in the Nordic Light Magazine, issued by the SwedCham in September 2015 and writen by Raphael de Campos Martins who is an Associate Lawyer from the Tax Team of Pacheco Neto, Sanden, Teisseire Advogados.