The Brazilian House of Representatives recently approved a bill containing broad and important changes in income taxation. Among these changes is the reinstatement of the Withholding Income Tax (“WHT”) on dividends paid by Brazilian companies to local or non-resident shareholders, at a rate of 15%. Dividend distributions have been exempt from income tax in Brazil since 1996.
Although the bill is still awaiting confirmation by the Brazilian Senate, non-Brazilian holders of equity interests in Brazilian companies are already considering the possibility of restructuring their investments in Brazilian companies, so that the direct owners of the investments are resident or domiciled in countries with which Brazil has entered into tax treaties providing for a WHT rate lower than 15% on dividend payments.
The following countries currently have tax treaties with Brazil providing for a maximum of 10% or 12.5% WHT rate on dividend payments, as long as certain conditions are met: Israel, Finland, Belgium, Chile, Japan, Peru, Mexico, Portugal, Russia, Switzerland, Trinidad & Tobago, Turkey, Ukraine, and Venezuela.
However, except for payments of dividends to a beneficiary resident in Japan, rates lower than 15% provided under these treaties would only apply in cases where the recipient of the dividends is the actual beneficial owner.
Therefore, establishing a holding company in any of those countries (excluded Japan) with the sole purpose of benefiting from the treaties’ rules, without any other business purpose and economic substance, would likely be deemed as a case of “treaty-shopping” by tax authorities, who would therefore likely challenge the favored taxation.
Based on the common interpretation of tax treaties and on the Brazilian domestic legislation, a holding company would only be deemed as the beneficial owner of dividends in cases where it cumulatively presents the following characteristics:
- Has economic substance, evidenced, for example, by holding other equity and/or financial investments, rather than equity stake in a single Brazilian company.
- Has legal personality of its own (i.e. it is not a pass-through entity) according to the laws of its place of incorporation.
- Is effectively domiciled in the relevant country, which requires that its administration/board of directors function there, as per Article 75, IV, of the Brazilian Civil Code. This includes taking corporate decisions and signing the respective resolutions; approval of the company's annual accounts; operation of its bank accounts; keeping of corporate books and accounting; decisions regarding investments/divestments and to hire third party investment advisors, managers or consultants; the legal representation of the entity; among others.
- Has the power and operational capacity to effectively manage and dispose of its investments, for example taking decisions with the purpose of generating income deriving from its investments (e.g., profit distributions and capital gains).
In other words, the entity must be a “real” holding company and effectively operate as such. In any other cases, tax treaties would not be a safe way out and the high risk of Brazilian tax authorities challenging the favored taxation make this strategy unadvisable.
This risk would be lower – though not inexistent – in case the holding company was established in Japan, because the tax treaty between Brazil and Japan makes no reference to the term “beneficial owner”.
The momentum for passing the bill into law has waned in recent weeks, due to political divergences between the House of Representatives and the Senate, as well as political friction between President Bolsonaro, the Brazilian Supreme Court and Congress. This is a good time to evaluate options to safely mitigate taxation without falling into pitfalls of apparently easy solutions.