Measure for measure

 

The Brazilian government introduced Provisional Measure 1.171/2023 (the Measure) on 30 April 2023. The Measure is one of the first legislative steps the government has taken to clarify the tax treatment of trusts in Brazil. It proposes a major overhaul of how Brazil taxes the offshore income of individuals. The Measure will impose tax on offshore financial investments, expand controlled foreign corporation rules to individuals and clarify the taxation of trusts.

Key features of trusts

A settlor can settle a trust and may fund it by making a gratuitous transfer of property to the trustee. Alternatively, a settlor can sell property to the trust; trusts are flexible as to the type of property that can be held in trust. The trust instrument, along with the governing law of the trust, governs the relationship of the trustee, settlor and beneficiaries, both to each other and to the trust assets. The trust instrument may set terms and conditions on the management and beneficial enjoyment of the trust assets. The trust instrument will also identify the beneficiaries.

A trust instrument will ordinarily specify a governing law. The governing law is important because it governs the validity and interpretation of the trust, and disputes in relation to the trust are generally resolved in accordance with the governing law. Many trusts are established under the laws of common-law jurisdictions (whose laws derive from England and Wales) because trusts originated from common-law principles.

A trust can offer several benefits, including:

• jurisdictional flexibility;
• dispositive flexibility;
• the ability to establish a management structure for property;
• family governance; and
• wealth preservation.

Civil-law jurisdictions and the use of trusts in Latin American jurisdictions

Although the trust is a common-law concept, trusts may be used by residents of civil-law jurisdictions for international planning unless applicable local laws otherwise restrict their use.

Indeed, several civil-law jurisdictions have created or amended their own laws to adopt trusts or trust-law concepts. Examples include Liechtenstein, Mexico, Panama, and the province of Quebec, among others. The trust laws of civil-law jurisdictions that have adopted trust concepts often differ substantially from the trust laws of common-law jurisdictions. Panama is the only Latin American jurisdiction to have adopted the Hague Convention of 1 July 1985 on the Law Applicable to Trusts and on their Recognition (the Convention).^[1]

The trust concept is similar to the Latin fiducia (i.e., fiduciary), which ‘originally concerned the transfer of property to a creditor or manager by a formal act of sale, yet with an agreement that the creditor would reconvey the property upon payment of a debt’.^[2] According to this account, ‘the primary difference between the common-law trust and the fiducia is that a trust beneficiary has a legal right to property in the trust, while a fiducia beneficiary is, in essence, no more than a mere creditor’.^[3]

This distinction is evident in some of the civil-law constructs that share similarities with trusts. For example, in the case of a fideicomiso,^[4] the trustee’s (fideicomisario’s) rights do not limit the fiduciario’s disposal of the property. The fiduciario’s only limitation is to transfer the trust corpus to the fideicomisario upon the occurrence of a condition. While the fideicomiso is pending, the fideicomisario does not have any rights over the trust corpus; they will only receive what remains following the use of or disposition by the fiduciario.^[5]

According to Dante Figueroa, the main differences between the Latin American fideicomiso and the general common-law inter vivos trust are as follows:

• The fiduciario does not correspond to the trustee in common-law trust terms, since they do not hold the corpus in their own name. The legal and equitable ownership rights converge fully on the fiduciario, while the essential task of the trustee of a common-law trust is to hold the property for another.
• The beneficiaries are not analogous, as the common-law trust beneficiaries possess equitable rights to the trust assets that a civil-law construct does not have.
• The French Civil Code eliminated the possibility of creating two or more successive fideicomisos, whereas the common rule against perpetuities may apply to a common-law trust.
• The common-law trust instrument may provide powers of appointment for the involvement of a third party. This is unusual in Latin American structures.
• Finally, Latin American courts do not have sufficient (if any) case law to intervene in the appointment or removal of trustees; however, common-law courts enjoy equitable powers to appoint and remove a trustee in disputes regarding their appointment.^[6]

Commentators have noted that the lack of case law dealing with trusts in Latin American courts is a major issue. Author Eduardo Salomão Neto notes that it would take significant movement for the Brazilian judicial system to be prepared to solve trust litigation disputes in Brazil:

‘[S]uch adoption would prepare the judicial body and provide them with a structure that is complex enough to allow intervention in the trusts. This would undoubtedly be costly, and reforming such a magnitude could not have priority over other more pressing yearnings that must be satisfied by the judiciary. The speeding up of justice to meet existing needs, fulfilling its social and political scope of securing fair means for the settlement of disputes between individuals and social groups, as well as ensuring the enjoyment of public freedoms constitutionally foreseen’.^[7]

Common-law trusts may also (to varying degrees) protect assets from claims of creditors. This is not the case in a fideicomiso.

Trusts in Brazil

Brazilian law does not recognise trusts or provide for a trust concept.

Article 7 of the Introduction to the Civil Code^[8] states that the law where the party is domiciled shall govern its legal capacity. This stands for the proposition that if a trust is recognised as such in the jurisdiction in which it is situated then Brazilian law should respect its characterisation under its governing law. Brazilian law is, however, unclear on the characterisation of trusts for tax and other purposes. From a practical standpoint, the official registration agency would likely not allow a trust to be a shareholder of a Brazilian company due to the non-recognition of trusts for Brazilian-law purposes. Usually, Brazilian assets could be contributed into an offshore entity, with the trust later receiving the shares or participation in those vehicles. From the Brazilian civil-law perspective, the Brazilian-resident settlor is subject to forced-heirship and marital property rules that the trust may not avoid.

It is imperative that Brazilian residents seek legal advice when establishing a trust. Trustees and non-Brazilian settlors may also wish to take advice when dealing with Brazilian-resident beneficiaries. The Measure takes a major step forward in clarifying the Brazilian treatment of trusts for tax purposes.

Brazilian tax law considerations for trusts

From a tax perspective, the two key taxable events are the transfer of assets from the settlor to the trustee and the receipt of distributions by beneficiaries.

Brazilian-resident individuals are generally subject to Brazilian income tax on their worldwide income at progressive rates of 0 per cent to 27.5 per cent, depending on the specific tax bracket. Capital gains are subject to a progressive rate of 15 per cent to 22.5 per cent. Brazilian individual income taxation is a system of monthly taxation, known as current basis taxation. Every year, Brazilian individuals must file an income tax return in which the taxpayer must declare all assets held both in and outside of Brazil.

Although gifts are not subject to income tax in Brazil, they are subject to the tax on transfer of assets by donation or causa mortis (the so-called ITCMD),^[9] which is a variable state tax. São Paulo charges a 4 per cent transfer tax, while Rio de Janeiro charges 4–8 per cent.

A Brazilian individual could opt for a revocable or irrevocable trust. The revocable trust is usually treated as transparent for tax purposes. The settlor of a revocable trust should report the value of the assets contributed to the trust as the initial contribution to the Brazilian tax authorities in their Brazilian tax return and the market value of said assets to the Central Bank of Brazil. Since the settlor of a revocable trust retains powers over the trust assets (namely, the right to revoke), there is a strong position that no ITCMD should be levied on the initial transfer from the settlor to the revocable trust.

In the case of distributions from a revocable trust to a beneficiary other than the settlor, there is a position that the distribution may be considered as a gift or inheritance from the settlor to the beneficiary, up to the amount of the capital contributions made by the settlor to the trust. The distributions from the trust’s income account should be treated as income distribution, subject to an income tax rate of up to 27.5 per cent. The taxation of the distributions to the settlor or upon their total or partial revocation should be analysed individually.

This said, it is important to highlight that this position is not settled in Brazil and is highly debated due to the lack of direct guidance dealing with the taxation of trusts. After the publication of Private Ruling 41/2020 (the Ruling), discussed below, a more conservative position is that any distribution from the trust, including capital distributions, is subject to the income tax rate of 27.5 per cent.

A distribution from an irrevocable trust could be viewed as a gift or anticipation of inheritance because the settlor does not have the beneficial ownership of the trust assets in the case of an irrevocable trust. In an irrevocable trust, the settlor has transferred full ownership of the property and has no right to revoke the trust and revest the property. For this reason, the transfer of the assets to an irrevocable trust should be subject to ITCMD.

From a Brazilian tax perspective, the beneficiaries of an irrevocable trust will have to report the trust either monthly or annually, depending on their rights under the trust. At this time, before the Measure goes into effect, the rights to trust distributions can be reported for income tax purposes as a gift or inheritance, depending on the presence of a condition precedent to the beneficiary having a vested right. For irrevocable trusts, it is important to analyse the moment when the beneficiary becomes fully vested in the rights over any trust assets.

During the Brazilian amnesty programme,^[10] the Brazilian tax authority issued guidance on how to report foreign trusts for the first time. However, such regulations did not recognise trusts under Brazilian law and such guidance was limited to the amnesty programme. Indeed, there are several different views on how to properly treat a trust for tax purposes in Brazil.

The Ruling

The Brazilian tax authority published the Ruling on 31 March 2020, which describes the tax treatment of distributions made by trusts to Brazilian beneficiaries. The Ruling analysed the Brazilian taxation of trust distributions for the first time and is binding on the Brazilian tax authorities.

In the Ruling, the taxpayer was the beneficiary of a trust established under the laws of the Bahamas, of which her husband was the settlor. After the death of her husband, the taxpayer started to receive distributions from the trust as beneficiary. The taxpayer sought a ruling on whether the amounts received from the trust should be subject to individual income tax or estate tax in Brazil. The analysis of the Brazilian tax authority relied on the existing Brazilian tax rules, which did not specifically address trusts. The tax authority analysed the legislation provided by the taxpayer in the Ruling, which dealt only with the taxation of income of Brazilian tax residents on non-Brazilian-source income.

Preliminarily, the Brazilian tax authority ruled that:

• because estate tax is regulated and levied by the states, and is not a federal tax, it would decline to address the estate tax questions raised by the taxpayer; and
• the concept of trust can have more than one meaning so, for the purposes of the Ruling, it adopted the concept of art.2 of the Convention, to which Brazil is not a signatory.

In other words, the tax authority viewed the trust as a legal relationship created inter vivos or after death, in which the grantor places their assets under the control of a trustee for the benefit of a specific beneficiary or purpose. Notably, in the Ruling, the tax authority did not have access to the content, purpose and conditions of the trust, so the analysis was based solely on the information provided by the taxpayer. After explaining how it viewed the trust in general, the tax authority ruled that the distributions made by the trust should be characterised as taxable income, subject to monthly payments under the ordinary income tax rate (up to 27.5 per cent).

The Ruling failed to analyse the possible application of the exemption of individual income tax on the amounts received as an inheritance, under the terms of art.6, XVI of Law 7,7713/88, for the assets contributed to the trust.

The São Paulo tax authorities published Private Ruling n. 25343/2022 on 4 April 2023. It dealt with a Brazilian beneficiary who requested a ruling on whether:

• a distribution from an irrevocable trust would be considered a gift; and, if so
• the beneficiary should pay the ITCMD according to state law, even taking into account the Brazilian Supreme Federal Court (the Court) judgment in Extraordinary Appeal No. 851,108.

According to the limited facts disclosed in the published ruling, the irrevocable trust was formed in 2017 and the settlor assigned assets of a non-Brazilian company to the trust with persons other than the settlor named as beneficiaries. The trust has a period of 150 years or more. The settlor was not a beneficiary. The tax authorities did not analyse the trust instrument or letter of wishes.

The ruling stated that ITCMD is triggered at the moment the Brazilian individual beneficiary is indicated by the settlor as a beneficiary of the trust. The ruling disregarded the Court decision in Extraordinary Appeal No. 851,108 and stated that, in São Paulo (the domicile of the beneficiary in the ruling), it is possible to charge the ITCMD based on art.4 of State Law n. 10.705/2000. Therefore, based on this position and if the beneficiary is domiciled in São Paulo, the tax authorities may charge the ITCMD to the beneficiary, as a grantee.

In summary, there are two main principles of interpretation from these authorities:

• If the Brazilian beneficiaries receive all the trust assets upon the passing of the settlor, it could be reasonably argued that the trust fund was an inheritance left by the settlor that would not be subject to income tax (up to the amount of the capital in historical local currency) or ITCMD. According to the current law and case law from the Court, there is no ITCMD in cases of inheritance if the assets are not located in Brazil. However, the accumulated earnings over the years, including earnings from the appreciation of the foreign currency over the years, should be treated as distributions from foreign sources, which are subject to the Brazilian ordinary income tax rate up to 27.5 per cent.
• In cases where the trust provides annual (or other periodic) distributions to the beneficiaries rather than a lump-sum payment, it is likely that Brazilian tax authorities would treat this periodic distribution (i.e., the total actual amount distributed over the years) as general distributions from a foreign source, subject to an individual income tax rate up to 27.5 per cent, and not as inheritance.

As there are no specific rules on the taxation of trust distributions to Brazilian beneficiaries under current law, the reasoning to achieve this conclusion is supported in very limited case law and administrative guidance.

Brazilian taxpayers must evaluate each situation carefully based on its own circumstances. This analysis should take into account, among other facts, the actual instrument for the incorporation of the structure abroad and the form of contribution and segregation of the relevant assets.

The Measure and its provisions on trusts

On 30 April 2023, the Brazilian government published the Measure, which proposes major changes to the Brazilian taxation of Brazilian tax-resident individuals. If the Measure is enacted as proposed, the new rules would be applicable from 1 January 2024.

The Measure establishes that individuals residing in Brazil on 1 January 2024 are subject to individual income tax (IRPF)^[11] separately and definitively on the income from capital invested abroad in the modalities of:

• financial investments;
• profits of foreign controlled entities; and
• assets and rights owned by a foreign trust (such income/earnings will be subject to progressive rates up to 22.5 per cent without deductions).

The main provisions of the Measure regarding trusts provide that:

• Assets and rights owned by a foreign trust will be considered under the ownership of the settlor after the establishment of the trust and will pass to the ownership of the beneficiary at the time of distribution by the trust to the beneficiary or of the settlor’s passing (whichever occurs first).
• The distribution from the trust to the beneficiary is a donation if transferred in life or a causa mortis transfer if resulting from the settlor’s passing.
• Income and capital gains related to the assets and rights owned by the trust to be earned as from 1 January 2024 will be:
  • deemed earned by the holder (settlor or beneficiary) of such assets and rights on the respective date; and
  • subject to IRPF in accordance with the rules applicable to the holder.
• The trust will be considered transparent for tax purposes when it holds a controlled entity abroad, applying the taxation rules set forth for controlled entities.

In summary, the Measure provides for automatic annual taxation of profits earned by controlled entities abroad (the anti-deferral rule). That is, from 1 January 2024, the profits generated outside of Brazil, based on the controlled entity’s annual balance sheet, will be taxed on 31 December of each year at progressive rates of up to 22.5 per cent.

The Measure defines a controlled entity as the company and other entities (incorporated or unincorporated) where the individual, directly or indirectly, separately or through other related entities, holds:

• the majority of the powers to manage the entity and/or to elect and remove the majority of its officers; or
• more than 50 per cent interest in the share capital, or equivalent, or in the rights to receive its profits or receive its assets in the event of liquidation.

These anti-deferral rules shall be applicable only to controlled entities:

• located in a country or dependency with a favoured tax regime (low-tax jurisdiction);
• with beneficiaries of a privileged tax regime; or
• with active income of less than 80 per cent of total income. Financial investments, for example, are one of the examples of deemed passive income, according to the Measure.

The Measure does not distinguish between revocable and irrevocable trusts. The failure to distinguish between revocable and irrevocable trusts can lead to divergence with treatment of irrevocable trusts in other jurisdictions.

As explained above, one of the interpretations of Brazilian tax rules under current law is the treatment of the irrevocable trust as a complete gift of the settlor. In this case, the settlor would not have ownership over the assets after the transfer of the assets. Under the new rules of the Measure, the settlor would nonetheless have to report and pay tax on the underlying assets, which can create a mismatch in the tax treatment of the same structure abroad.

US tax treatment of irrevocable trusts

US tax law distinguishes between ‘grantor trusts’ and ‘non-grantor trusts’. For US federal income tax purposes, a grantor trust is generally disregarded as separate from the grantor (e.g., the settlor). Accordingly, the grantor of a grantor trust is subject to income tax on income earned within the trust.

A trust funded by a non-US person (as determined for US income tax purposes) can qualify as a grantor trust if:

• the grantor retains the power to revoke and revest the trust assets during the grantor’s lifetime; or
• the only distributions from the trust during the grantor’s lifetime are made to the grantor and/or their spouse. A trust funded by a US person can qualify as a grantor trust in a broader set of situations.

It is possible to design an irrevocable trust to be a grantor trust or a non-grantor trust. A non-grantor trust is treated as a separate taxpayer for US federal income tax purposes and is subject to US federal income tax on its income. The tax liability will vary based on several factors including whether it is a US non-grantor trust or a non-US non-grantor trust, as well as the type of assets and income of the trust.

A US non-grantor trust is subject to income tax generally in the same manner as an individual. Therefore, a trust is subject to ordinary income tax at a maximum 37 per cent rate and is subject to tax on qualified dividend income and long-term capital gains at a rate of 20 per cent. Certain non-grantor trusts are also subject to a 3.8 per cent net investment income tax. When a non-grantor trust distributes current income to a beneficiary, the beneficiary will generally include the distribution in its income and the trust should be eligible to deduct the distribution. Non-US non-grantor trusts are subject to US federal income tax generally only on their US-source income. US beneficiaries of non-grantor trusts are subject to complex anti-deferral rules.

As the Measure does not distinguish between revocable and irrevocable trusts, there is a potential mismatch between the tax treatments of an irrevocable trust in Brazil and the US tax treatment of the trust as a separate entity if it is a non-grantor trust. This mismatch could give rise to disparate reporting requirements in Brazil and the US, and could give rise to double taxation absent clarifying guidance.

Conclusion

Trusts have a long history in common-law jurisdictions and are one of the major wealth-planning tools for global families. Prior to the Measure, there has been a dearth of guidance dealing with trust issues for Brazilian families. The Measure represents a giant leap for Brazil’s treatment of trusts. However, advisors to Brazilian families should evaluate the implications of the Measure for their planning and should account for cross-jurisdictional differences to maximise opportunities and minimise risks.^[12]