Global Emerging Markets: Asia, Africa, theMiddle East, and Latin AmericaInvesting in Brazil: Overview of the Legal Landscape
October 2, 2013 | The St. Regis Houston | Houston, TX
Panelists
Carolina UtimatiSenior Associate, Tax GroupSão Paulo, Brazil
Trench Rossi e WatanabeAdvogados, associated withBaker & McKenzie InternationalTel: +55 11 3048 [email protected]
Alberto MoriPartner, M&A/Corporate GroupSão Paulo, Brazil
Trench Rossi e WatanabeAdvogados, associated withBaker & McKenzie InternationalTel: +55 11 [email protected]
Decreasing cost to invest in Brazil
In order to expand its economy in afaster pace Brazil is offering:
– Opportunities for foreigncompanies (e.g., need ofinfrastructure, pre-salt Oil & Gasprojects, etc)
– Stimulus for investment
– Brazilian economic/politic/socialenvironment still good
Considerations forForeign Investors
Structuring Your Business
New Legal Entity (JV or wholly-owned)
– Limited Liability Quota Company
– Corporation (S.A.)
Non-Incorporated Joint Ventures
– Consortia – tax efficient pass-through vehicle
– Joint Operating Arrangements – freely to negotiate
Acquisition of an existing entity
– Due Diligence should cover financial health, corporateand tax compliance, labor, tax and civil litigation,criminal/FCPA compliance, regulatory requirements,environmental compliance and IP issues
Registration and Repatriation of ForeignInvestment
General rule: inflow and outflow of funds are free
Foreign investments must be registered with Central Bank
Foreign-registered investment can be repatriated in therelevant foreign currency free of taxes up to theproportional amount of foreign currency registered withBACEN. The exceeding amount is considered a capitalgain and is subject to 15% withholding income tax
Avoiding and Surviving Disputes
– Local culture based on personal relationships andamicable resolution of disputes
– If amicable resolution fails, court system is usuallyoverloaded and not prepared to handle commercialdisputes
– Arbitration is the instrument of choice to solvecommercial disputes. However, investors shouldconsider costs, nature of the dispute, arbitration chamber,enforceability of arbitration clause etc.
Anti-Bribery/Compliance – A serious Issue
– Trend of increased enforcement in Brazil
– Applicable laws – in certain instances more severe than inother jurisdictions
– New Anticorruption Law: strict liability of legal entities andtheir individuals with distinct sentences; existence of acompliance program may be a mitigating factor
Environmental Matters
– Civil joint and severalstrict liability
– Criminal liability which mayinvolve the legal entity as well
– Administrative Liability
– Enforcement through administrative assessments, classactions, consent agreements and criminal lawsuits
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Top 5 Legal Issuesin Brazil
Don’t overlook the red tape
Doing business in Brazil requires special attention to legalrequirements and bureaucratic procedures.
For instance, inflow and outflow of funds to Brazil requireregistration investment with the Central Bank and someexchange controls apply. Expatriation of foreign workers aresubject to limitations and requires visas. Complying with taxancillary obligations and accounting book-keeping demandsseveral hours of work per year.
In a nutshell, those procedures should not be overlooked byan new investor in the Brazilian market.
Don’t rely too much on the four corners of theagreement…
Brazil has a civil law system in which several principles andpublic order rules prevail over the wording of the contract.Accordingly, a party often cannot infer the full range of itscontractual rights and obligations only by reading the “fourcorners of the agreement”.
Brazilian law tends to be pro-debtor and pro-weakest party.
Brazilian courts are slow. As a general rule, it is advisable toprovide for arbitration in larger transactions.
The green issues
Compliance with environmental regulation has becomeincreasingly important over the last few years.
However, environmental regulation is sometimesburdensome and, as to certain issues, both the FederalUnion, the member-states and the city authorities have thepower to regulate.
Accordingly, good environmental law advice might be one ofthe keys for success in the Brazilian market, if the activity ispotentially pollutant.
The hurdles of an inflexible labor law
Most Brazilian labor laws date back from the 40`s and mirrorsome European rules, granting several mandatory benefitsand giving very few flexibility to the employer to negotiatesuch benefits with the employees. There are limitations, forinstance, for wage reduction and overtime work.
For every cent of wage paid to the employee, the employershall pay almost another cent in taxes (e.g., social securitycontributions and union contributions) and benefits (e.g.,mandatory contribution to the FGTS fund, Christmas bonus,vacation bonus, etc).
Life’s sure thing, especially in Brazil: taxes
Brazil has a complicated tax system, with more than 40 differenttaxes.
For instance, there are taxes equivalent to VAT on a federal (IPI),state (ICMS) and local (ISS) levels, sometimes with overlappingtriggering events and creating “tax wars” between states andcities to attract investments.
Taxes take more than 35% of the Brazilian GDP, which is thehighest percentage in countries of similar level of development.
Compliance with ancillary tax obligations in Brazil is deemed to beone of the most demanding in developing countries.
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Top 5 Legal Issues
For M&A in Brazil
KYC – Know your counterparty
Many Brazilian local companies operate with a great deal ofinformality and have “shadow” accounting.
Any purchaser should carry out not only a legal duediligence but also a strong accounting due diligence to findin advance any compliance issue.
Material assets and contracts
Buyer should be careful to ensure that seller really has titleto all material assets (e.g., the assets may belong to othercompany of the group).
Buyer should check if the change of control will trigger earlytermination of material contracts.
Business may be quite personalistic in Brazil. It might becrucial to have a non-compete from sellers’ “rainmakers”and to have retention agreements with key personnel.
Environmental
Environmental rules are increasingly becoming stricter.
It is important to have a complete environmental duediligence and, if necessary, a technical due diligence,including phase 2 underground survey.
In case there is an environmental contamination, purchasermay require the target to implement remediation measuresand/or enter into an agreement with the environmentalauthorities.
LaborBrazil’s labor law is very protective to the employee and quite inflexible. SomeBrazilian companies do not fully comply with those rules, especially as regardspayment of overtime and other labor benefits as well as HSE issues.
It is not unusual for a Brazilian company to have a labor claim per eachemployee dismissed in the past few years.
Everyone who is “subordinated” to the company shall be treated as employee.Therefore, many people who are supposedly service providers might qualify forlabor benefits.
Certain highly paid officers might be deemed to be employees and qualify forlabor benefits, including expatriates.
Labor claims cannot be settled out of the labor court.
Labor issues are usually handled through clear representation and warrantiesand strong guarantees (eg., escrow, pledges etc).
Tax
It is not unusual for Brazilian targets to be involved in tax evasion orfailure to comply with tax obligations.
Tax requires comprehensive due diligence not only from a legalperspective, but also from accounting and compliance standpoint.
Target may be sometimes required to entered into programs for paymentof outstanding taxes in installments and/or tax amnesties that from timeto time are issued, with payment from funds of the purchase price, so asto enable the deal.
Implement asset deals do not isolate the Buyer from the Targetbusiness’ past liabilities. Under this structure the Buyer is secondaryliable – which is a thin protection if it buys all operating assets.
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Tax Issues(Entering, Repatriating Profits andExiting Brazil)
Topics
1. Entering in Brazil
- Investment in Brazil: assets versus stock acquisition
- Funding acquisition and activities in Brazil
2. Repatriation of Profits
- Repatriation of profits: tax aspects on the payment ofdividends and interest on equity abroad
- Opportunity - payment of IOE of prior years
3. Exiting Brazil
- Capital gains of non-residents depending on the type ofinvestment
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Entering Brazil
Investment in Brazil – Tax Aspects
– Assets Acquisition
– Share Acquisition
– Funding Investments in Brazil with Debt
– Thin Capitalization Rules
Local Acquisition of Assets
BrazilianTarget
Assets
Inventory
Fixed Assets
Real Estate
Others
– The local sale of assets may be subject totransactional taxes depending on the natureof the assets transferred (i.e.; PIS, COFINS,ICMS, IPI and ITBI)
– In a transfer of a going concern the ICMSand the IPI are not levied – provided that thebusiness unit is transferred in the acquisitionand there is no physical transfer of assets
– Tax losses carryforwards (NOLs) recorded bythe Brazilian entity are not written-off uponthe sale of assets
– If the transaction is deemed as a sale ofbusiness (“going concern”) the legislationprovides for the tax succession liability atNewco’s level on a secondary basis.
Brazil
ForeignInvestor
Newco$
Brazil – Acquisitions
$
Acquisition of Stock
– Sale of shares is exempt oftransactional taxes (i.e.; ICMS, PIS,Cofins, IPI and ITBI)
– Goodwill paid by a legal entity in Brazilfor the acquisition of shares of anotherlegal entity in Brazil is subject to taxamortization
– Tax losses carryforwards (NOLs)recorded by the Brazilian target arewritten-off in case of cumulativetransfer of line of business andcorporate control
– In the acquisition of shares, the buyersteps on the shoes of the seller for taxliability purposes
Seller Acquisition Vehicle
Target Target
$
Brazil – Acquisitions
Target
Buyer
Net Equity = 20
Purchase Price = 60
Investment= 20
Goodwill = 40
Goodwill according to tax laws – differencebetween the price paid and the net bookvalue of the fixed assets, based on one ofthe following:
–Expectation of future profitability
– Difference between accounting value andmarket value of fixed assets
– Other Intangibles/ Other economic reasons
Local Acquisition of Stock – Payment of Goodwill
Brazil – Acquisitions
– Economic study supporting the amount and the nature of goodwill paid in theacquisition of the investment
– Liquidation of the investment (i.e., merger of acquisition vehicle into Target)
– Goodwill based on expectation of the Target’s future profitability – amortization:maximum 1/60 per month - minimum 5 years for tax purposes
– Goodwill based on the difference between the accounting and market value offixed assets – depreciation: remaining period of the assets’ useful life
– Goodwill based on other intangibles: no tax amortization allowed
Local Acquisition of Stock – Requirements for TaxAmortization of Goodwill
Brazil – Acquisitions
Buyer
Target
– The merger of the target into the Buyer (or vice-versa) isrequired to the allow the tax amortization of goodwill paidin the acquisition of the Target
– The merger based on book value is generally a tax freereorganization
– After the merger, goodwill paid in the acquisition of Targetmay be amortized for tax purposes, limited to 1/60 permonth (minimum amortization period is of 5 years)
– Discussion regarding goodwill amortization in view of thenew IFRS accounting rules in Brazil
Brazil – Acquisitions
Local Acquisition of Stock – Merger / Amortization ofGoodwill (based on expectation of future profitability)
Funding Activities in Brazil with DebtThin Capitalization Rules
– Introduced by Provisory Measure No. 472 (Dec. 15, 2009); Convertedinto Law No. 12,249 (June 11, 2010)
– Limitation on the deduction of interest payments to related partiesabroad – as defined by the transfer pricing legislation
– Beneficiaries established in regular tax jurisdictions
Debt equity ratio: 2:1
Thin Capitalization Rules
Debt equity ratio: 2:1 - Calculation– In case the related party holds equity interest in the Brazilian
company, the debt should not exceed two times the netequity of the Brazilian company held by such related party
– In case the related party does not hold equity interest in theBrazilian company, the debt should not exceed the total netequity of the Brazilian company
– In any event, the total amount of debt with related partiesshould not exceed two times the net equity of the Braziliancompany held by all related parties (not applicable if debtwith related parties that do not hold equity interest in theBrazilian company only)
Thin Capitalization – Example(2:1)Direct equity interest participation
Assumptions – Brazil Co.:
– Loan with A = 2000
–Interest: 10% (200)
–Net Equity = 800
Interest Deductible on loan with A:– Total Net Equity = 800– Equity Interest A (60%) = 480– Debt/ Equity Ratio 2:1 = 960
– Maximum Interest Deductible = 96
Parent
B CACash $2000
Brazil Co.
Regular TaxJurisdiction
Brazil
40%60%
Loan
$2000
Thin Capitalization - Example (2:1)No direct equity interest participation
Assumptions – Brazil Co.:
– Loan with C = 2000
– Interest: 10% (200)
–Net Equity = 800
Interest Deductible on loan with C:– Total Net Equity = 800– Equity Interest C = 0– Debt/ Equity Ratio 2:1 = 1.600
Maximum Interest Deductible = 160
Parent
B CACash $2000
Brazil Co.
Regular TaxJurisdiction
Brazil
40%60%
Loan
$2000
Loan
$2000
Thin Capitalization Rules
– Beneficiaries established in low tax jurisdictions or subject toprivileged tax regime (as defined by Articles 24 and 24-A of Law9,430/96), regardless of any equity participation held by the foreignparty in the Brazilian entity
Debt equity ratio: 0.3:1
Calculation:
– The total debt held by all parties established in low taxjurisdiction or subject to privileged tax regime should notexceed thirty percent of the net equity of the Braziliancompany
Thin Capitalization – Example(0.3:1)
Assumptions – Brazil Co.:
– Loan with A = 2000
– Interest: 10% (200)
–Net Equity = 800
Interest Deductible on loan with A:– Total Net Equity = 800–Debt/ Equity Ratio 0.3:1 = 240
– Maximum Interest Deductible = 24
ACash $2000
Brazil Co.
Low TaxJurisdiction/
Privileged TaxRegime
Brazil
Loan
$2000
Thin Capitalization Rules
– The concept of debt includes all types of financing transactions(regardless of any registration with the Central Bank) and alsotransactions with third parties where a related party act as guarantor,attorney in fact or as intervening party
– In case there is an excess in relation to the limits provided in thelegislation, the interest accrued over such excess should beconsidered a non-deductible expense in Brazil
– Good arguments to support that the two limits (2:1 and 0.3:1) mayapply together
Low Tax JurisdictionsNew jurisdictions included by IN 1037/10 (in addition tothose listed by IN 188/02)
– Ascension Island;
– Kiribati;
– Brunei;
– Norfolk Island;
– Pitcairn Island;
– French Polynesia;
– Qeshm Island;
– Saint Helena Island;
– Saint Pierre and Miquelon Island;
– Solomon Island;
– Swaziland;
– Switzerland - temporarily excluded
– Tristan da Cunha.
Privileged Tax RegimesRegimes Listed by IN 1037/10– with respect to the legislation of Luxembourg, the regime applicable to holding companies; - permanently revoked
by Declaratory Act No. 3/11
– with respect to the legislation of Uruguay, the regime applicable to the "Inversion Financial Entities" (Safis)incorporated until December 31, 2010;
– with respect to the legislation of Denmark; the regime applicable to holding companies that do not carry substantiveeconomic activities;
– with respect to the legislation of the Netherlands, the regime applicable to holding companies that do not carrysubstantive economic activities;– temporarily excluded;
– with respect to the legislation of Iceland; the regime applicable to legal entities incorporated as International TradingCompanies (ITC);
– with respect to the legislation of Hungary, the regime applicable to KFT offshore companies;
– with respect to the legislation of the United States of America, the regime applicable to the state Limited LiabilityCompanies (LLC), whose corporate ownership is composed by non-residents, not subject to the federal incometax;
– with respect to the legislation of Spain, the regime applicable to the "Entidad de Tenencia de Valores Extranjeros"(E.T.V.Es.); and ;– temporarily excluded;
– with respect to the legislation of Malta, the regime applicable to the International Trading Company (ITC) andInternational Holding Company (IHC).
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Repatriation of Profits
Repatriation of Profits – Tax Aspects
– Dividends distributions from Brazil
– No withholding income taxes regardless of the domicileof the beneficiary
– Not deductible expense
– Interest on equity
– Remuneration of the capital based on the profits of thecompany
– Subject to withholding income tax of 15% or 25% incase the beneficiary is domiciled in a low tax jurisdiction
– Deductible expense at the payor entity
Brazil – Planning Relating to Brazilian Companies
– Interest on Equity – Opportunity
– Deductibility at 34% / WHT at 15% (25% if beneficiary is in low tax jurisdiction)
– TJLP Interest rate over net equity accounts, except for: (i) the revaluation reserve(reserva de reavaliação), and (ii) the reserve for adjustment of fair value (ajuste deavaliação patrimonial) – Article 59 of Law No. 11,941/09
– Deduction is limited to either (i) 50% of the current profits (before any deduction of IOE),or (ii) 50% of the retained earnings
– Decisions (Nos. 107-08.941/07 and 101-96.751/08 – CSN ) from the AdministrativeCourt of Tax Appeals (CARF) recognized the possibility to declare and deduct IOEaccumulated with respect to past years. In the same sense, Superior Court of Justice’sDecision No.1.086.752 (date Feb. 2009)
– Opportunity: deduction currently of the IOE calculated over the net equity of prior years
Brazil – Planning Relating to Brazilian Companies
– Interest on Equity – Opportunity
Controversial Aspects:
- Reserve: need to calculate the net equity of a given year reducing the IOE payable in one year from the net equity of thecompany in the following year
- Accrual regime: losses in the year vs. mere postponement
2007 2008 2009 2010
Capital 100,00 100,00 100,00 100,00Retained Earnings -20,00 -30,00 -35,00 415,00Reserve Fair Value 0,00 0,00 0,00 0,00Current Earnings -10,00 -5,00 450,00 60,00
Interest Rate (TJLP) 6,3750% 6,2496% 6,1248% 6,0000%
Basis for TJLP 80,00 70,00 65,00 515,00TJLP over Net Equity 5,10 4,37 3,98 30,90
IOE Deductible each Year 0,00 0,00 4,00 30,90
IOE Deductible in 2010 5,10 4,37 3,98 30,90
44,36
50% Current Earnings -5,00 -2,50 225,00 30,0050% Retained Earnings -10,00 -15,00 -17,50 207,50
Interest on Equity
Net Equity Accounts
Years
Profits Limitation
Sum IOE Deductible in 2010related to Prior Years
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Exiting Brazil
Exiting Brazil– Capital gains
– Capital gains in the sale of shares of a Brazilian entity incase of direct investment
– Subject to withholding income tax of 15% or 25% incase the beneficiary is domiciled in a low tax jurisdiction
– Capital gains are calculated based on the differencebetween the sale’s price and the cost basis of theinvestment. In general, the foreign investmentregistered with the Central Bank of Brazil (“RDE”) isaccepted by the tax authorities as the cost basis forpurposes of calculation of capital gains in the sale ofshares of a Brazilian entity
Exiting Brazil– Capital gains
– Capital gains in the sale of shares of a Brazilian entity incase of investment in portfolio (2,689 Regime)
– The sale of shares held as portfolio investment inpublicly held entities is exempt of capital gains. Thisregime does not apply to beneficiaries domiciled in lowtax jurisdictions
Exiting Brazil– Capital gains
– The sale of a holding entity abroad is not subject tocapital gains in Brazil. However, there is a taxassessment from the tax authorities challenging the saleof a holding entity, which sole asset was interestparticipation in a Brazilian entity (analysis of substanceversus form)
– It is recommended that the planning for capital gainpurposes should be implemented as from theacquisition in order to increase the argumentssupporting the sale of a holding entity abroad
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