Global Tax Alert. Brazil enacts tax reform

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1 15 May 2014 Global Tax Alert News from Americas Tax Center EY Americas Tax Center The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Services/Tax/Americas-Tax- Center---borderless-clientservice Brazil enacts tax reform Executive summary Brazil has enacted corporate tax reform, Law of 13 May (the Law), which is the broadest and deepest reform to Brazil s corporate income tax system since the enactment of Decree-Law of 26 December The Law differs from the Provisional Measure (PM 627) introduced in November 2013 by eliminating the restrictions on goodwill and making substantial changes to the proposed controlled foreign corporation (CFC) regime included in PM 627. Detailed discussion Background To appreciate the changes in the current corporate tax reform from a tax accounting perspective, it is important to reflect on the history in this part of the law. On 28 December 2007, Decree Law was substantially amended by Law , which provided the foundation for the convergence of Brazilian statutory accounting with International Financial Reporting Standards (IFRS). The statutory accounting reform of Law /07 and the numerous convergence rules enacted by the Financial Accounting Statements Committee as from 2008 (Comitê de Pronunciamentos Contábeis or CPC) redefined the fundamental concepts of recognition of revenues, gains, expenses, and losses, as well as balance sheet and consolidation accounting methods. Law /07 introduced new provisions under Article 177 of Law 6.404/76, to state that all statutory accounting changes caused by the application of the new accounting rules would not alter any tax bases or have any other tax effects. This is what is commonly referred to as Brazil s tax neutrality principle in the context of IFRS convergence. The tax neutrality principle caused the Brazilian tax authorities to enact the so-called Transitory Tax Regime (Regime Tributário de Transição or RTT) in 2009 under PM 409/08 (later converted into Law /09). The RTT approach was originally scheduled to last for a two-year period during which a new regime would be developed and legislated. Its extension for over six years raised several issues, as it effectively required companies to keep two sets of statutory

2 accounting records (one of which was under the pre-2008 accounting principles that were no longer in force for any purpose other than the application of tax law). Several questions arose as to how to apply the tax neutrality principle, which caused many issues and differences of interpretation. Accounting changes Law /14 generally aims to turn into book to tax differences most of the items that under RTT were treated as pre-ifrs to post-ifrs statutory accounting differences. 2 In this sense, the Law preserves most of the key definitions of taxable income embedded in Decree-Law 1.598/77, and it also mandates that future statutory accounting changes shall not alter tax bases before the enactment of further amendments to the tax law (Article 58 of the Law), which tends to be a positive approach. Additionally, the Law eliminates the parallel transactional accounting established under the RTT, which is a welcomed change. In the earlier drafts of PM 627, the tax authority intended to create a parallel and permanent transactional accounting record that would remain under the pre-2008 accounting rules. That option was later acknowledged as unfeasible. Discussed drafts of the Law tried to curb what are perceived by the tax administration as abusive transactions, which historically allowed the recognition of taxdeductible goodwill in certain corporate reorganizations involving related parties and in some transactions involving like-kind exchanges. The restrictions on goodwill are not in the final version of the Law. As such, it is clear that an inside basis step-up remains available on qualified purchases and business combinations, and that such step-up also includes goodwill. Earlier drafts of the law attempted to eliminate the inside basis step-up. Yet, the tax authority, through its engagement with the private sector, decided to retain the inside basis stepup for economic policy reasons. The tax authority determined that the inside basis step-up fosters private investment and facilitates true acquisitions and business combinations. Finally, the Law maintains the dividends exemption declared out of statutory profits (post IFRS) accrued from 2008 to For fiscal year 2014, the same dividend exemption applies only if the taxpayer elects to adopt the new system as from It also maintains the use of such statutory accounting for purposes of determining and declaring interest on shareholders equity and equity accounting gains, in a move that limits the application of the tax neutrality principle for prior years, and in an effort to reduce the significant controversy and litigation that would be triggered by the application of Normative Instruction (NI) 1.397/13. 3 Worldwide basis of taxation and changes to the CFC regime In 1996, Brazil changed from a territorial to worldwide system by launching a rigorous CFC regime. Under the CFC regime, any type of corporate investment abroad, be it direct or through a branch or subsidiary, is subject to corporation tax on a current basis (at 31 December of each year), regardless of a foreign local tax burden, local substance of the foreign group company, and the active or passive nature of the operations carried out abroad. The combined headline rates of corporation tax (known under their Brazilian acronyms as IRPJ and CSLL) currently stand at 34%. A foreign tax credit generally is available, so that a Brazilian parent of a UK subsidiary, for example, that pays 21% local corporation tax is subject to a top-up tax of 13% in Brazil. Deferral of this tax is not possible. The Law s tax reform does not change the basic principles of the taxation in Brazil of foreign corporate profits. The Law makes the following primary changes: Modifies the technique to tax profits of overseas group companies Introduces an exemption for overseas group companies that earn profits related to oil and gas operations in Brazil Introduces individual taxation as a general rule but with a temporary option to consolidate the results of certain foreign subsidiaries and branches for Brazilian tax purposes Introduces a temporary presumed credit for overseas subsidiaries that are active in the food and beverage sector, or that engage in the construction of buildings or infrastructure projects 2 Global Tax Alert Americas Tax Center

3 Introduces a temporary provision to allow the payment of tax on foreign profits in installments Allows tax deferral for profits earned through affiliates (generally, minority interests) Technique of including profits of foreign group companies in the taxable basis of the Brazilian parent The Law distinguishes between foreign subsidiaries (broadly, a foreign legal entity in which the Brazilian company holds, directly or indirectly, the majority of the voting capital) and foreign affiliates. Foreign affiliates are, generally, entities in which the Brazilian investor has a significant influence, which is presumed to exist where it owns, directly or indirectly, 20% or more of the capital. Under the previous CFC regime, profits earned by affiliates were taxed on a current basis, just like subsidiaries. The constitutional court, Supremo Tribunal Federal - STF, however, held in April 2013 that this violated the constitution to the extent affiliates were not based in a tax haven. 4 Law accordingly provides that profits of foreign affiliates are generally taxed on a cash basis, while the profits of foreign subsidiaries are taxed on a current basis. Although a tax deferral may seem attractive, the Law eliminates the (underlying) credit for taxes paid by the affiliate on its profits, which may substantially increase the overall tax burden. Taxes paid by the parent on distributions received from the affiliate (such as withholding tax on dividends) can generally be credited. The Law modifies the technique to include profits of a foreign subsidiary on a current basis by requiring the Brazilian parent to revalue its investments annually such that the local accounting results (before tax) of that subsidiary for the relevant calendar year are included in the valuation. To avoid multiple inclusions of foreign profits where the corporate structure involves more than one tier, the results to be included are to be determined on a stand-alone basis. These foreign profits are then converted into Brazilian Reais using the foreign exchange rate at balance sheet date of the foreign company. Other foreign exchange fluctuations are excluded. Although the technique of taxing profits of another entity is thus repackaged as a revaluation exercise to be undertaken by the parent, the Law is quite clear that it only seeks to tax in Brazil profits earned abroad, irrespective of whether those profits have been, or could have been, distributed to Brazil. The Superior Tribunal da Justiça - STJ (the highest court in the land in non-constitutional matters) recently 5 held that the previous CFC regime is overruled by the business profits article of Brazil s tax treaties with Belgium, Denmark and Luxembourg. Where, in substance, the new CFC regime continues to tax the same foreign profits, it is highly uncertain as to whether the new CFC technique can be upheld in such a tax treaty context. During the legislative process, this tax treaty aspect has not been considered. Exemption for overseas group companies that earn profits related to oil and gas operations in Brazil A carve out from the CFC regime is provided to foreign subsidiaries and affiliates that earn profits directly related to oil and gas operations in Brazil. The Brazilian parent or investor of such a foreign subsidiary or affiliate is exempt from tax in Brazil on those profits. Temporary provision to consolidate the results of certain foreign subsidiaries and branches for Brazilian tax purposes A much debated aspect of the CFC regime is whether losses incurred abroad can be offset against foreign profits. Regulations issued by the Brazilian revenue authority under the previous CFC regime provide for a silo approach in which the first-tier (foreign) subsidiary and the results of all further tiers held by that subsidiary are consolidated with the balance being taxed in Brazil. This is known as vertical consolidation. The Law replaces the vertical consolidation by allowing results from overseas subsidiaries to be pooled regardless of the ownership structure. However, a subsidiary (direct or indirect) cannot participate in this consolidation, when one (or more) of the following conditions applies in respect of that subsidiary: The Brazilian parent does not make the statutory accounts and related documentation of the subsidiary available to the Brazilian revenue authority if it is situated in a country with which Brazil does not have a treaty or act 6 that provides for the exchange of information for tax purposes. Global Tax Alert Americas Tax Center 3

4 The subsidiary is resident or owned (directly or indirectly) by a resident in a tax haven jurisdiction or in a jurisdiction where it benefits from a preferential tax regime, 7 or it is subject to a low-tax regime. 8 The subsidiary s direct, active income is less than 80% of total income (items such as royalties, interest, rentals and certain dividends are deemed not to be active income). Foreign profits may only be consolidated through Temporary presumed credit for certain overseas subsidiaries Through 2022, the Law allows the Brazilian parent (subject to conditions) to deduct up to 9% as a presumed credit on the income derived from the investment revaluation in respect of foreign subsidiaries that are active in the food and beverage sector or that engage in the construction of buildings or in infrastructure projects. Installment payments for tax on foreign profits The Brazilian parent may opt to delay the payment of the CFC charge to the extent the foreign profits have not been distributed to it. This is subject to the inclusion of a minimum of 12.5% of the relevant profits in the year following the relevant accounting year. Any balance is due at the latest in the eighth year following the relevant accounting year. The unpaid tax is adjusted for interest, the rate of which is fixed at USD Libor, and foreign exchange fluctuations. In addition, payment in installments is not possible where the foreign (direct or indirect) subsidiary meets one (or more) of the following conditions: The subsidiary is resident or owned (directly or indirectly) by a resident in a tax haven jurisdiction or in a jurisdiction where it benefits from a preferential tax regime. 9 The subsidiary is subject to a lowtax regime. The subsidiary s direct, active income is less than 80% of total income. Effective date The Law is generally effective on 1 January However, taxpayers may elect to implement Articles 1 and 2 and 4 through 70 (i.e., IFRS convergence) for calendar year 2014, as well as the CFC regime. Once the election to early adopt is made, it is irrevocable. The election will be made on a form prescribed by the tax administration. The new form may require some degree of information technology systems adaptation, which almost certainly could not have been enabled by the second quarter of Early adoption in 2014 will facilitate the electronic audit of adjustments by the tax authority, and will reduce the potential litigation over the application of NI 1.397/13 in 2014 for taxpayers with pre and post- IFRS profits accounting difference. Endnotes 1. The start of the legislative process was the issue of Provisional Measure 627 (PM 627/13) of 12 November 2013, which was subsequently converted by National Congress and Senate (PLC 2/2014). After the president vetoed various parts, the text became final on 13 May 2014, and was published in the Official Gazette on 14 May From a compliance perspective and considering Brazil s electronic reporting systems, this change means the end of the Corporate Income Tax Return DIPJ, the end of the FCONT obligation, which reconciles preand post-ifrs accounting to produce the so-called RTT differences, as well as the non-application of the parallel transactional recordkeeping under pre-ifrs accounting rules established under NI 1.397/13. Instead, it requires only the use of the Public System of Digital Recordkeeping (SPED) along with a new electronic version of the Income Tax Registry LALUR (EFD or elalur) to demonstrate book-to-tax differences and tax calculation. This preserves the full traceability of all data and adjustments that is critical to Brazil s enforcement system and compliance environment. 4 Global Tax Alert Americas Tax Center

5 3. NI 1.397/13 was issued by Brazilian IRS to guide taxpayers on RTT. It is very aggressive in demanding the levy of taxes on dividends, interest on net equity and capital gains when accounting basis is higher than tax basis. The language of Law overrules such aggressiveness. 4. The case number is Adin See EY Global Tax Alert, Brazil s Superior Court of Justice rules CFC regime not compatible with tax treaties, dated 6 May Brazil signed the Convention on Mutual Administrative Assistance in Tax Matters in 2011, but has not yet ratified it. 7. As referred to in Articles 24 and 24-A of Law no of 27 December Defined as a regime pursuant to which the profits of a foreign domiciled legal entity are taxed at a rate below 20%. 9. As referred to in Articles 24 and 24-A of Law no of 27 December For additional information with respect to this Alert, please contact the following: Ernst & Young Serviços Tributários S.S., Business Tax Services, Sao Paulo Andres Valle andres.valle@br.ey.com Eneas Moreira eneas.moreira@br.ey.com Ernst & Young Serviços Tributários S.S., Global Compliance and Reporting, Sao Paulo Tatiana Ponte tatiana.ponte@br.ey.com Claudio Yano claudio.yano@br.ey.com Ernst & Young Serviços Tributários S.S., International Tax Services, Sao Paulo Luiz Sergio F. Vieira luiz.s.vieira@br.ey.com Ernst & Young Serviços Tributários S.S., International Tax Services, Rio de Janeiro Serge Huysmans serge.huysmans@br.ey.com Ernst & Young Tax Co., Brazilian Tax Desk, Tokyo Audrei Okada audrei.okada@jp.ey.com Ernst & Young LLP, Brazilian Tax Desk, New York Ingrid Berner ingrid.berner@ey.com Ernst & Young LLP (United Kingdom), Brazilian Tax Desk, London Felipe Bastos Fortes ffortes@uk.ey.com Global Tax Alert Americas Tax Center 5

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