TAX NEWS - 2010

Brazil Tax: Final thin capitalization rules introduced

Brazil's first thin capitalization rules have been converted into law and were published in the official gazette on 14 June 2010. The rules, set forth in Provisional Measure No. 472/09 (PM 472, published on 16 December 2009), are designed to prevent the under-capitalization of Brazilian companies and the use of excessive indebtedness.

As expected, the final rules maintain the two criteria for amounts paid or credited to be deductible – these rules take into account the relationship between the lender and the borrower, as well as the location of the lender. The debt-to-equity ratios differ depending on whether or not the interest is paid to a party (whether or not related) located in a tax haven jurisdiction or a jurisdiction with a privileged tax regime:

Where interest is paid or credited to a related party (whether or not a shareholder) not located in a tax haven or privileged tax regime jurisdiction, the related party debt-to-equity ratio may not exceed 2:1, calculated based on the proportion of related party debt to the direct equity investment made by the related party.

Under a "standalone deductibility test," each direct shareholder debt is compared to the net equity ownership of each direct shareholder.

For non-shareholders, each non-shareholder debt is compared to the debtor's total net equity.

A second test requires that the overall debt-to-net equity ratio, as calculated based on the total related party debt (shareholders only) versus the total related party net equity ownership, not exceed 2:1. Non-shareholder related party debt for this purpose is compared to the debtor's total net equity.

Interest paid or credited to a company or individual located in a tax haven or a jurisdiction that has a privileged tax regime, as defined under Brazilian law, may be deducted provided the debt-to-equity ratio does not exceed 0.3:1. The deductibility of interest expense is limited by reference to the ratio that the total amount of debt with any foreign party located in a tax haven jurisdiction/privileged tax regime, whether or not the party is related, bears to the total net equity of the Brazilian borrower. The tax haven/privileged tax regime jurisdictions are in black and grey lists recently issued by the Brazilian authorities.
 
In both instances, the interest expense must be necessary for the Brazilian company's operations, so that even if the debt-to-equity ratios are respected, unnecessary leverage can be disregarded by the Brazilian tax authorities. For purposes of determining the total indebtedness, all financing forms and terms must be taken into account, regardless of whether the transactions are registered with the Brazilian Central Bank. Further, there are provisions that bring back-to-back arrangements and loans guaranteed or co-signed by any related party of the debtor company within the scope of the thin capitalization rules.

The final version of the thin capitalization rules clarifies one of the controversial aspects of the original version, i.e. the applicability of the debt-to-equity ratio on debt paid to a related party that does not have an equity interest in the Brazilian payer company. According to the final version, the 2:1 threshold applies to all related party debt regardless of the extent of the shareholding. The 0.3:1 debt-to-net equity ratio is still applicable to debt with a company or individual (whether or not related) located in a tax haven or jurisdiction with a privileged tax regime.

With respect to the mechanics of the calculation, the net equity accounts to be used for purposes of the limits on the deductibility of interest expense should be in accordance with Brazilian GAAP (now equivalent to IFRS), and the calculation should be made using the monthly weighted average method, meaning that the thin capitalization test should be applied on a monthly basis.

According to the final wording of the law, the new thin capitalization rules should be effective as from 1 January 2010 and no specific reference is made to any difference between entry into effect for purposes of corporate income tax (IRPJ) and purposes of the Social Contribution on Net Income (CSLL). However, whether the rules should be effective for calendar year 2010 is the most controversial issue of PM 472. Some tax experts are taking the position that, under the Brazilian Constitution, the thin capitalization rules cannot become effective for at least 90 days after publication in the official gazette for purposes of the CSLL and not until the year following that in which PM 472 is converted into law for IRPJ purposes. Nevertheless, the wording of the law implies that the Brazilian tax authorities may try to apply the rules retroactively as from 1 January 2010 and, therefore, taxpayers should evaluate any tax risks associated with their positions taken.