Paradigm shift

A series of tax changes were enacted in Brazil towards the end of 2023. The new legislation, Law No. 14,754/2023 (the Law), is dubbed an income tax reform as it targets practically all types of investment structures utilised so far by Brazilian private clients for tax deferral and succession planning. These structures include local private/family mutual funds and offshore controlled entities like investment business companies, private label funds and trusts.

In general, under previous legislation these structures were taxed only in case of a distribution to their beneficial owner. As an example, for local multimarket closed-end funds, income tax would be levied solely upon amortisation of shares and only upon the payment of dividends or in the event of a capital reduction for offshore private investment companies. Consequently, as long as assets were held under these vehicles and there was no kind of redemption of earnings, tax income would be deferred.

Brazilian funds under the Law

The Law brought two main impacts to Brazilian investment funds:

• All income tax deferred until the end of 2023 on closed-end funds in general was subject to taxation.
• Effective as of 2024, the valuation of these funds’ shares is now subject to income tax at the end of May and November every year. This system anticipates the income tax due on a redemption and is known in Brazil as come-cotas, because income tax is collected under a compulsory redemption of shares in favour of the Brazilian federal revenue service.

On the other hand, the Law preserved the tax deferral for some types of local investment vehicles like equity funds (FIA) and some structured funds like private equity and receivables funds (FIP and FIDC, respectively). FIA are subject to income tax only in the event of redemption or amortisation of shares and are not in scope of the Law, as their portfolio is subject to higher volatility. Likewise, providing that an FIP or FIDC’s main objectives remain focused on capital gains and its investment manager has a discretionary mandate, income tax will still be deferred until the redemption or amortisation of shares.

Concerning non-resident investors in Brazil, the Law also preserved the tax incentives and exemptions that these entities and individuals have if investing in Brazilian funds and other financial assets (provided that these investors are not resident or incorporated in or under privileged jurisdictions and regimes).[1]

New rules for offshore investments

In terms of offshore assets, the Law brought deeper innovations in three areas. It created controlled foreign company (CFC) rules in Brazil and determined that those CFCs must follow one of two possible tax regimes: transparency or non-transparency. In addition, the Law offers a voluntary step-up in basis for offshore assets. Finally, it established a tax treatment for trusts with Brazilian-tax-resident settlors and beneficiaries.

Scope of the CFC rules

To determine whether an offshore company is under the CFC rules’ scope, the Law created a two-prong test. In the first prong, the determining factor is the control of the CFC by Brazilian-tax-resident individuals and their related parties (the Controlling Block).[2] Control is proven by two possible criteria: economic or political control. Political control is proven if the Controlling Block either:

• holds more than 50 per cent of the voting capital; or
• is entitled to receive more than 50 per cent of the CFC’s profits or of its assets in case of a liquidation.

Alternatively, the entity will be politically controlled if the Controlling Block:

• has predominance in the shareholder’s voting; or
• is capable of appointing or removing most of the board.

Once financial or political control is proven, the second prong will evaluate if the CFC is incorporated in or under privileged jurisdictions and regimes or if it derives more than 60 per cent of its revenue from passive income. If the two prongs are met, the CFC rules apply and the taxpayer will elect to treat the respective CFC as a transparent or a non-transparent entity.

Transparent CFCs

In the transparent regime, the taxpayer is taxed on the offshore income annually as if the assets were held directly by the individual. The taxation is triggered on a cash basis (income tax is levied only when the sole asset is sold, liquidated, redeemed or in an asset distribution) and will be calculated in BRL.[3] In their annual income tax return, the taxpayer will be able to deduct all realised losses during the year, and should the aggregated result of the yearly transactions be positive, the individual will be subject to an income tax rate of 15 per cent on it. However, if the aggregated result ends in a loss, it will be used to offset gains and incomes earned during subsequent years.

Non-transparent CFCs

In the non-transparent regime, the income tax is levied annually on the CFC’s net income, which is reflected on the financial statements according to Brazilian generally accepted accounting principles.[4] Therefore, the entity’s losses, expenses and liabilities reduce the net income, while the fair value of the financial assets is registered as valuation. As a result, any increment in value accrued from one fiscal year to the following should already be subject to taxation, irrespective of the CFC assets’ sale, liquidation or redemption. In this regime, the net income is also subject to an annual 15 per cent tax charge and eventual losses may also be deducted from future incomes. Once net income is annually taxed, such income may be distributed to the CFC’s shareholders without any further taxation.

Step-up in basis

The Law also brought an exceptional voluntary step-up in basis for offshore assets, as individuals are able to update their offshore assets’ original cost to their fair market value since 31 December 2023, subject to an income tax levy of 8 per cent on the capital gain accrued. Nevertheless, such option is not available for some collectibles, such as jewellery and art.

Taxation of trusts

Historically, Brazilian legislation has never recognised nor determined a tax treatment for trusts and other similar entities.[5] This lack of clear rules created opportunity for an administrative ruling that disregarded important factors about trusts when treating these structures, especially in cases of income distributions.[6] The Law finally set boundaries on how trusts should be treated by their Brazilian settlor and/or beneficiaries.

In summary, trusts are to be considered transparent structures and the income derived from their assets is either taxed by the settlor or the beneficiaries as follows:

• Should the trust be revocable, during their lifetime the settlor will be obligated to pay tax on all the income derived from the trust.
• Distributions shall be considered either a gift, if made during the settlor’s lifetime, or inheritance, if made upon the settlor’s passing. In addition, whenever the trust becomes irrevocable, the Law considers it a fictional transfer to beneficiaries as well.

In this new scenario, irrevocable trusts set up before the Law represent a burden to their settlor and beneficiaries, who will pay taxes on income derived from assets no longer accessible to them. It is yet to be answered how trustees will react to their request for disclosure and resources to comply with their new tax obligations.

Conclusion

The Law upturned received wisdom on Brazilian wealth planning, as the definition of which is the most adequate investment vehicle is now deeply related to an individual’s asset allocation and what the long-term expectations of private clients are for their portfolio, both onshore and offshore.

Many questions remain open while practitioners construct their own interpretation of the new rules. Adaptation is the new name of the game.