Brazilian tax authorities Issue controversial “Tax Blacklist” which includes the United States Limited Liability Company.
BY RICHARD L WINSTON
On June 7, 2010, the Brazilian tax authorities released SRF No. 1,037/10, which contains the long-awaited "tax blacklist" of (1) "low tax jurisdictions" and (2) "tax privileged regimes."
The new blacklist specifically lists the United States Limited Liability Company ("U.S. LLC") as a "tax privileged regime" when the membership of the U.S. LLC "is composed of nonresidents, not subject to federal income taxation." The U.S. LLC was not listed as a "low tax entity." The United States "corporation" avoided both blacklists.
Nonresident entities that are incorporated in a jurisdiction that qualifies as either a "low tax jurisdiction" or a "tax privileged jurisdiction" are generally subject to unfriendly Brazilian tax rules. The most punitive Brazilian tax rules, however, generally apply only to nonresident entities located in "low tax jurisdictions."
Prior to June 2008, the Brazilian tax authorities had considered only the concept of the "low tax jurisdiction." A "low tax jurisdiction" was generally defined as a jurisdiction that taxed its residents at a tax rate of less than 20 percent. Nonresident entities formed in "low tax jurisdictions" were subject to various limitations and additional taxes when doing business with Brazilian companies. Some of these limitations and additional taxes included:
(1) The denial of benefits for CMN No. 2,689 Investments (e.g., exemption from capital gains on the disposition of shares in a publicly traded Brazilian company);
(2) The increase in withholding tax from 15 percent to 25 percent on interest, royalties, and charter payments;
(3) The increase in withholding tax from 15 percent to 25 percent on capital gains (non-publicly traded companies);
(4) 15 percent withholding tax on FIP distributions;
(5) Enhanced "transfer pricing" scrutiny (including scrutiny of transactions with unrelated parties); and
(6) The denial of beneficial customs treatment ("Linha Azul").
The Brazilian tax authorities published a consolidated blacklist in 2002 to describe all of the jurisdictions that constituted "low tax jurisdictions." This blacklist became the main point of reference for the tax authorities and practitioners when determining whether a jurisdiction would be considered a "low tax jurisdiction." Nonresident entities formed in jurisdictions that were not blacklisted by the Brazilian tax authorities generally escaped scrutiny as "low taxed entities" even if the jurisdiction where the entity was formed did not tax its residents at a 20% or greater tax rate.
In June 2008, the Brazilian government passed a new tax law (effective January 1, 2009) that expanded the definition of a "low tax jurisdiction" to include issues related to the disclosure of corporate owners and corporate secrecy. Moreover, the new Brazilian law created the new concept of the "tax privileged regime" to address future "transfer pricing" issues. The test to determine whether a regime would be "tax privileged" for purposes of transfer pricing was based on a new four-prong analysis.
No new tax blacklist was published to accompany the June 2008 tax law changes. Moreover, the new tax law revealed to practitioners that the Brazilian tax authorities would start to look beyond a "country-by-country" blacklist (towards a new blacklist that would include special taxing regimes within a country). Aside from shifting transfer pricing issues into the new category of "tax privileged regimes," all of the other limitations and additional taxes that historically applied to entities formed in "low tax jurisdictions" (stated above) remained the same.
After the new concept of the "tax privileged regime" was created in June 2008, the concept was expanded in late 2009 to place tougher Brazilian "thin capitalization" restrictions on parent companies lending money to their Brazilian subsidiaries. In an isolated case, the Brazilian tax authorities also improperly applied the new concept of the "tax privileged regime" to deny "Linha Azul" customs benefits to a Brazilian company owned by a Delaware LLC.
The two main limitations that now apply to entities that are formed under "tax privileged regimes" are summarized immediately below:
(1) Enhanced "transfer pricing" scrutiny; and
(2) Stricter "thin capitalization" standards (0.3:1 debt/equity ratio rather than a 2:1 ratio).
After the June 2008 law was introduced without an accompanying tax blacklist, many tax practitioners believed that it would be unfair (and maybe even unconstitutional) to impose limitations or additional taxes on nonresident entities located in specific jurisdictions until the Brazilian tax authorities published a new "blacklist" to clarify the specific countries or regimes that should be considered "low tax jurisdictions" and/or "tax privileged regimes." The new tax blacklist has now been published to address these concerns.
TAX IMPACT ON US LLC IN BRAZIL
As discussed above, the U.S. LLC (owned by nonresidents not subject to U.S. taxation) was designated on the new blacklist as a "tax privileged regime" rather than as a "low tax jurisdiction." Thus, Brazilian investors that do business with a U.S. LLC (owned by nonresidents not subject to U.S. taxation) may be subject to tougher "transfer pricing" scrutiny. Brazilian companies that are owned by a U.S. LLC (owned by nonresidents not subject to U.S. taxation) will also be subject to tougher thin capitalization restrictions (1:3 debt/equity ratio rather than a 2:1 ratio). Finally, the U.S. LLC has already been the subject of at least one attack by the Brazilian tax authorities whereby the Brazilian subsidiary of a parent U.S. LLC failed to qualify for "Linha Azul" importation benefits.
The new designation of the U.S. LLC as a "tax privileged regime" rather than as a "low tax jurisdiction" was welcomed by the many offshore investment funds that use the single-member U.S. LLC as a "blocker" company to make their CMN No. 2,689 Investments into Brazil. Under CMN No. 2,689, the U.S. LLC has always enjoyed an exemption from Brazilian capital gains tax upon the disposition of the Brazilian investment (as well as many other benefits). The single-member LLC is generally treated as a "disregarded" entity for U.S. federal income tax purposes, so investment funds that have invested in Brazil through the U.S. LLC have been able to avoid both U.S. and Brazilian tax obligations. If the U.S. LLC were considered a "low tax jurisdiction," CMN No. 2,689 Investment benefits would be lost.
To summarize, the U.S. LLC (as a "tax privileged regime") is not subject to higher Brazilian withholding taxes on interest, royalties, and gains. The U.S. LLC will not lose its CMN No. 2,689 Investment benefits. Moreover, the U.S. LLC will not be subject to withholding taxes when receiving distributions from a FIP. However, the U.S. LLC will be subject to the additional transfer pricing and thin capitalization scrutiny described above.
ANALYSIS OF THE NEW BRAZILIAN STANDARD FOR THE U.S. LLC
As discussed above, a U.S. LLC "whose membership is composed of nonresidents, not subject to federal income tax" is specifically listed as a "tax privileged regime." Under the U.S. tax system, the U.S. LLC itself is never subject to federal income tax unless it has filed a special U.S. tax election to be treated as a taxable U.S. corporation. However, the members of a U.S. LLC may themselves be subject to U.S. taxation (based on the "flow through" tax treatment of the LLC) if the LLC earns "effectively connected income" in the United States.
Based on the literal wording of the new rules presented, an LLC may be "tainted" as a "tax privileged regime" even if it has only a single 0.01 percent nonresident owner who is not subject to U.S. federal income tax. The small nonresident owners would not be subject to U.S. federal income tax if, for example, the U.S. LLC has no U.S. "effectively connected income" attributable to a U.S. trade or business (even though the 99.99 percent U.S. owners would be subject to full U.S. taxation on their respective shares of the LLC's income).
In the same respect, a single 100 percent nonresident (tax haven) owner of a U.S. LLC that earns US$1 of "effectively connected income" could seemingly protect the LLC from being "tainted" if the nonresident owner files a U.S. tax return to report the US$1 on behalf of the LLC. In this case, the nonresident owner of the U.S. LLC would be "subject to U.S. federal taxation." The new rules could be interpreted to take this "all or nothing" approach (i.e., an LLC whose members are "subject to U.S. taxation" should not be blacklisted), although some practitioners believe that a U.S. LLC with any nonresident owners will be “tainted.” This particular issue will require further clarification from the tax authorities.
BRAZILIAN TAX AUTHORITY’S “INVITATION TO FOREIGN COUNTRIES TO FILE AN APPLICATION TO REQUEST REVISIONS TO THE BRAZILIAN BLACKLIST
The new normative ruling SRF No. 1,037/10 (providing the new tax blacklist) is only an "interpretive" ruling. The Brazilian tax authorities can change their positions at any time, and it is unclear whether the tax authorities may decide to expand their list of "low tax jurisdictions" to include the entire new list of "tax privileged regimes."
On June 23, 2010, the Brazilian tax authorities published new amendments to the existing tax blacklist rules that allow any foreign country to file an application to request revisions to the tax blacklist. The application must be sent by the government of the requesting jurisdiction to the Secretary of the Brazilian tax authorities. The application must present substantive reasons that merit revisions to the blacklist. It appears that the governments of Switzerland and the Netherlands were already negotiating their tax standing with the Brazilian tax authorities before the June 23 amendments were issued. On June 25, 2010, Switzerland was removed from the list of “low taxed” jurisdictions. That same day, the Dutch “holding company” was removed from the list of “tax privileged” regimes.
The United States Treasury will likely analyze the recent decision of the Brazilian tax authorities to categorize the U.S. LLC as a “tax privileged regime” and decide on a course of action. The United States Treasury will need to decide whether it should advocate to either entirely remove the U.S. LLC from the blacklist or to modify the rules that determine when a U.S. LLC should be treated as a “tax privileged regime.” To most nonresident investment funds that invest into Brazil through the U.S. LLC, CMN No. 2,689 is a critical benefit. To most large and medium-sized multinational companies investing into Brazil through U.S. LLCs, the preferential tax withholding rates on interest and royalties represent an important issue.
In light of the widely publicized negative comments of the Brazilian tax authorities towards the U.S. LLC (as well as the Delaware LLC), it is possible that the Brazilian government may try to designate the U.S. LLC as a "low tax jurisdiction" in the future (in fact, the new rule itself already refers to the U.S. LLC as possibly "not subject to U.S. federal taxation").
REPLACEMENT INVESTMENT VEHICLES FOR THE U.S. LLC
The new tax blacklist for "privileged regimes" surprisingly contains a list of many popular European entities including, but not limited to, holding companies found in Spain, Malta, Denmark, and Luxembourg. Many of these investment vehicles were once thought to be safe from the attack of the Brazilian tax authorities. Some nonresident investors had even considered these international corporate vehicles as potential replacements for the U.S. LLC. At this point, all of these international investment vehicles are now similarly situated to the U.S. LLC (pending further clarification from the Brazilian tax authorities).
On the other hand, there are still many structural options available to replace the U.S. LLC if the tax treatment of the LLC ever creates a negative result for an investor. Among the replacement options include U.S. state “limited partnerships,” Canadian limited partnerships, UK LLPs, Dutch CVs, etc. These regimes can, if structured properly, present the same tax benefits to nonresident investors as the U.S. LLC.
Richard L Winston is a partner at K&L Gates. To review a more detailed discussion on the Brazilian tax treatment of tax havens, please see his presentation to the Brazilian-American Chamber of Commerce of NY on July 7, 2009 titled The Future of Tax Havens and Recent Brazilian Anti-Tax Avoidance Measures.