Investors need to pay careful attention to their cash flow for Brazil, bearing in mind that if a foreign loan needs to be (partially) repaid in a short period of time after being granted, the whole principal amount may be subject to IOF at a rate of 6%
Brazil, understandably, has been attracting quite a large amount of foreign investment. It is a country that offers investors huge opportunities, with a domestic market attractive not only because of its sheer size but also because of its steadily increasing purchasing power.
On the other hand, given Brazil’s somewhat bureaucratic model and complex tax system, investors need to be aware that proper planning and cautious implementation are very important in order to secure a positive outcome for their investments. This also holds true when it comes to financing their activities – especially if the local operations are to be financed by the partners themselves, with their own funds, or by other related parties resident abroad.
Since the end of 2009 Brazil’s government has made changes to the country’s tax legislation, introducing thin capitalization rules. Such rules are normally focused on limiting the amount of interest that may be deductible for corporate income tax purposes, when such interest is payable under a foreign loan contracted between related parties. Brazilian thin capitalization rules apply differently depending on whether or not the beneficiary of the interest payments is resident in a tax haven jurisdiction. Where the beneficiary is not a resident in a low-tax jurisdiction, interest paid or credited by a Brazilian entity to a related party will only be deductible for corporate income tax purposes if the entity complies with a debt-toequity ratio of 2:1 (that is to say, interest relating to the part of a foreign loan contracted with a related party that exceeds twice the amount of net equity of the Brazilian borrower is not deductible for Corporate Income Tax in Brazil). On the other hand, if the beneficiary of the payment is resident in a tax haven jurisdiction, the interest expense will only be deductible for Brazilian income tax purposes if the total amount of the Brazilian entity’s debt with any foreign party resident or domiciled in a tax haven jurisdiction does not exceed 30% of the entity’s net equity.
Additional restrictions on the deductibility of interest have also been introduced during 2012 in the Brazilian Transfer Pricing legislation, and will be applicable from January 2013. According to the new rules, interest on related party foreign loans, even if duly registered with the Brazilian Central Bank, will be deductible only up to an interest rate equal to the LIBOR dollar rate for six-month loans plus a 3% annual spread (Ministry of Finance can reduce this percentage or restate it). In other words, interest paid abroad on an amount that exceeds the threshold shall not be deductible in Brazil, regardless of being subject to withholding income tax in Brazil.
Finally, investors need to pay careful attention to their cash flow for Brazil, bearing in mind that if a foreign loan needs to be (partially) repaid in a short period of time after being granted, the whole principal amount may be subject to IOF at a rate of 6%. IOF is a tax on financial operations and is levied, for example, on foreign exchange transactions. In accordance with Decree number 7,853, published on December 5th 2012, the applicable IOF tax rate of 6% will be applicable to foreign currency exchange transactions (inflow of funds into the country only) related to cross-border loans (including, but not being limited to intercompany loans) subject to registration at the Brazilian Central Bank, with an average payment term of up to three hundred and sixty days (1 year). Conversely, if the average maturity date is longer than three hundred and sixty days, the rate is reduced to 0%.
The “effective” payment term (and not just the contractual provisions for the payment term) is key to determining the applicable IOF rate. The 6% rate will also apply to cross-border loans that are liquidated prior to an originally contracted maturity date which exceeds 1 year (interest and penalties will also apply).
One aspect to be considered is that over the past few years the Brazilian government has regularly amended the IOF legislation, especially in relation to foreign exchange transactions, following the appreciation or depreciation of the Brazilian currency vis-a-vis the US Dollar. In line with that, the term for application of the zero percent IOF rate has been stretched and/or reduced quite a number of times in the past couple of years. Just a few months ago such zero percent rate would only apply to loans with an average payment term of more than 5 years – which, depending on the needs of the company in question, may be too long a period for cash to be trapped.
Considering the above, and indeed some other issues such as taxation of foreign exchange variation and of debt forgiveness, foreign investors should carefully analyse their financing requirements in Brazil, their cash availability, and the opportunities at hand in order to determine what would be the best option for funding local alternatives. In certain cases funding via equity may be more beneficial / less prejudicial, especially when considering that in Brazil it is possible to distribute remuneration based on equity that may be deductible for corporate income tax purposes.
Gustavo Carmona Sanches
Senior Tax Manager in the International Tax practice at PWC in Brazil
This article is taken from Brazil Business Brief, January 2013.